Audit Risks of Melbourne Automobile Company - Case Study Example

The Australian Auditing Standard 315 Customer Inserts His/her Name Customer Inserts Grade Course Customer Inserts Tutor’s Name 07/05/ 2011 Introduction The Australian Auditing Standard (ASA) 315 was developed with reference to the International Standard of Accounting (ISA) 315. The two standards require: ASA 315 Understanding the Entity and its Environment and Assessing the Risks of Material Misstatement, while ISA 315: Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and its Environment. The ASA 315 was issued by the Auditing and Assurance Standards Board (AUASB) an independent statutory board of the Australian Government. The ASA 315 was therefore established in pursuant to the requirements of the legislative provisions and strategic direction. Findings As part of audit procedure, an auditor of the automobile company needs to understand its business environment in order to identify potential risks that have a significant effect on the financial statements. To attain this understanding of the client’s business environment, the auditor needs to acquire relevant information about the clients which can be acquired through various sources as provided by ASA 315.6. These sources of information include: management and from other employees, analytical procedures and through observation and inspection. An auditor should integrate all these sources to attain complete information. The auditor should consider whether the information acquired is relevant to identifying risks of material misstatements. This information should provide the auditor with an understanding of the automobile company internal control, control environment, selection and execution of accounting policies, nature of the entity, that is, its operations, ownership and governance structures, planned or present investments and it financing methodology in accordance with ASA 315.11. This information will help the auditor to assess and evaluate the risks associated with the Melbourne Automobile Company. There are certain audit risks factors associated with the Melbourne Automobile Company. Audit risks refer to the possibility that an auditor will issue unqualified or inappropriate opinion on financial statements after the audit even when there are material misstatements (Sandler et al 1998). An auditor should identify and assess the risks of material misstatement at the financial report level and at the assertion level for classes of transactions, account balances and disclosure to provide a basis for executing the audit procedures. The Melbourne Automobile Company deals with buying and selling of BMW, Mercedes Benz and Prestige cars. Risk factors are associated with inherent, detection and control risks. Risk factors associated with business risk in Melbourne Automobile Company include: economic climate, technological change, competition, business volatility and geographical location. Economic climate may be considered in relation to the overall economy of Australia based on inflation and interest rates. The most recent economy dilemma is the reduced supply of oil products and their relatively high prices. There are major technological changes occurring in the business environment that pose a risk to automobile company. Competition a risk factor based with Melbourne competitor’s strategies such as Toyota Automobile Company. Risk factors affecting financial reporting risk include: competence and integrity of management, incentives of management to misstate financial statements, complexity of transactions and internal control system. When evaluating the financial reporting risk, the auditor considers the items on a company’s balance sheet that are subjective and based on judgment. Puttick et al (2008) states that an auditor considers the risk that errors will occur (inherent risk), the risk that the Melbourne internal control system will fail to prevent, detect or correct errors (control risk) and the risk that auditor’s procedures will fail to detect errors (detection risk). Melbourne Automobile Company Identification of significant risk Potential risk description Amount Account Assertion Level of Inherent risk Uncollectable debtors $5 million Sales Existence High Unpaid creditors $1 million Purchases Allocation Low Unpaid taxes $200 Income/ expense Completeness Low Insurance $3 million Expense Rights/obligations High As indicated in the table above, the potential risk of uncollectable debtors affect the sales account and the associated inherent risk is high. This is because there could be many debtors who fail to pay for the purchase of the cars. Unpaid creditors affect the purchases account and the inherent risk is low since Melbourne applies a strong internal control. Unpaid taxes reflect both on income and expense account since the amount reflects an increase in revenue, while per ser, a tax is an expense to Melbourne. Insurance risk is significant risk in the automobile industry associated with many procedures that Melbourne has to undergo for cars that are intended for sale and other insured premises. In support of the above Melbourne could have $15 million uncollectable debtors because the debtors have failed to honor the sales term. This is a high inherent risk since some bad debts that Melbourne cannot fully rely own. Unpaid creditors may be estimated at $40 since Melbourne is aware of the risk of bankruptcy associated with unpaid creditors thus indicating a low inherent risk. The unpaid taxes of Melbourne are relatively low since we assume that the company complies with the government and other authority regulations. The approximated taxes are $200 thus indicating a low inherent risk. Insurance expenses are estimated at a high level of $3 million thus indicating a high inherent risk. This is because Melbourne has to consider insurance costs associated with the cars intended for sale and those to be bought The term assertion means representations by management and those charged with governance, explicit or otherwise, that are embodied in the financial report as used by the auditor to consider the different types of potential misstatements that may occur. This can be achieved through designing, implementing and maintaining an internal control system by the management and other authorized personnel. The auditor performs the risk assessment procedures to provide a basis for the identification and assessment of material misstatements. According to Pickett (2006) internal auditors may provide training and or information on internal control identification and assessment, risk assessment and test plan development without altering the objectivity of the audit plan. Recommendations In order to eliminate the possibility of assessing audit risk as too low in Melbourne Automobile Company, an auditor should obtain an understanding of the organization and its environment, identify risks that may result in material misstatements, evaluate the organization’s response to those risks, assess the risk of material misstatement and evaluate results and issue an audit report. However, risks assessment procedures do not provide adequate audit evidence on which an auditor can base opinion on. The risk assessment procedures are conducted to identify and assess material misstatements. An auditor issues an audit opinion based on materiality and audit risks concepts. Audit risk is defined in the context of materiality since it is the risk that an auditor will issue an inappropriate or unqualified audit report on materially misstated financial statements. Rittenberg et al (2009, 866) adds that an auditor conducts materiality judgments to make sure that the auditor gathers sufficient evidential matter to obtain reasonable assurance that the financial statements are free of material misstatements. Complex materiality judgments can be disclosed as notes in the financial statements. The auditor should obtain an understanding of whether Melbourne has a process for identifying business risks and their significance. Other risk areas associated with Melbourne Automobile Company include: incompetence of employees; supervision of employees; inaccurate accounting records; failure to adhere to the required accounting policies, authorization of transactions and segregation of duties. These areas may lead an auditor to give unqualified report even when there are material misstatements around these areas. When conducting an audit plan, the auditor should consider the audit risk areas of Melbourne based on audit evidence and provide audit procedures. This will help the auditor in identifying and assessing the risks of material misstatements through understanding the Melbourne and its environment. Conclusions The auditor can gather audit evidence through certain techniques as explained by Ainapure and Ainapure (2010). These audit evidence techniques include: those planned in audit programme, adopting audit techniques, used in audit procedures and recorded in audit working papers. The auditor should consider the most appropriate audit evidence technique based on the nature, timing and extent of the client’s work. This will provide the auditor with a base to give his opinion on the financial statements. According to Gupta (2004, 1145) material misstatement may be presented in relation to audit risk either as an individual transaction or an aggregate. The purpose of considering the materiality of financial statements is to achieve a true and fair presentation of financial information. Materiality may be influenced by individual considerations, legal requirements and compliance or non compliance with the accounting policies. An auditor should evaluate the quality (nature) and quantity (amount) of a material statement. An example of nature of a misstatement is when the preparer of financial statement has intentionally avoided application of certain accounting policy that is important in providing true and fair financial information. Executive Summary Risks associated with the Melbourne Automobile Company can be classified as business, financial reporting, engagement and audit risk. Business risks affect the operations and potential outcomes of organizational activities while financial reporting risks relates to recording of transactions and presentation of financial data in am organization’s financial statements. On the other hand, engagement risk is the risk of a client’s loss of reputation; fail to pay an auditor and dishonesty of the management. These risks are also associated with the state of Melbourne Automobile Company. A major type of risk in an automobile company is the insurance risks on cars intended for sale. The objective of ASA 315 is to prescribe mandatory requirements in relation to the auditor’s responsibility to identify and assess the risks of material misstatement, whether due to fraud or error, at the financial report and assertion levels, through understanding the entity and its environment, including the entity’s internal control, thereby providing a basis for designing and implementing responses to the assessed risks of material misstatement. An auditor is required to assess and evaluate the client since there are different audit procedures associated with every client. Therefore, an audit procedure for a company in an automobile industry such as Melbourne will differ from an audit procedure in another industry (AASB 2009). References Auditing and Assurance Standards Board (AASB) 2009, ASA 315 Understanding The Entity And Its Environment And Assessing The Risks Of Material Misstatement, Retrieved at http://www.comlaw.gov.au/Details/F2009L04079. Ainapure & Ainapure 2010, Auditing And Assurance, 2nd Ed, PHI Learning Pvt. Ltd. Gupta, A 2004, Contemporary Accounting, 6th Ed, Tata McGraw-Hill Education. Pickett, Spencer KH 2006, Audit Planning: A Risk Based Approach, John Wiley and Sons Puttick, G, Sandy E & Suresh K 2008, The Principles and Practice of Auditing, 9th Ed, Juta and Company Ltd. Rittenberg, LE, Karla J & Gramling AA 2009, Auditing: A Business Risk Approach, 7th Ed, Cengage Learning. Sandler, E, Hamel A & Staden M 1998, Auditing Final Approach Read More