Let’s see if we can IDENTIFY AND EXPLAIN the AUDIT RISKS in the following scenario (in the exam, the scenario will have much more detail).
Dionne McScuggery, Chair and CEO of Vegan Sausages International, a listed company, summons the audit manager to her office in order to discuss the following:
1. An equity settled share-based pay scheme for senior company executives was introduced this year, but the company is not proposing to recognise it in the financial statements because no one knows how to account for it.
2. A major retail customer, Bristles, has cancelled their contract after a pricing dispute. As a result of losing the contract 30% of the staff will be made redundant.
Four points NOT to make in the answer:
1. It would be tempting to explain the ethical risk of our offering assistance with the calculation of the share-based pay – but we weren’t asked to, so don’t.
2. It would be even more tempting to discuss the business risks of losing a major customer and suggesting strategies to replace the customer – but that would be fish market gossip.
3. It is also be tempting to explain the audit procedures to tackle the audit risks identified – but that would make the examiner weep. Only give procedures if asked for them.
4. Finally, it might be very tempting indeed to DEFINE inherent, control and detection risks.
Again, a very bad idea, because we weren’t asked for definitions.
So, what are we supposed to write? When planning the answer we need to remember that audit risk exists at two levels:
1. The financial statement level: This means that some factors in the scenario could cause the whole set of financial statements to be wrong. There are three factors to look out for, and they are all in the scenario above:
a. The business may not be a going concern. We can link this to the loss of the major customer as follows. “As a result of the loss of the contract with Bristles, the client may not be able to cover its fixed costs, and therefore may not be a going concern.”
b. The business may have weak internal controls. We could link this to the governance issue, because Dionne is both Chair and CEO.
“There is a governance weakness because Dionne is both Chair and CEO. Therefore, decisions to manipulate accounting policies may go unchallenged.” Alternatively, we could link it to the lack of financial expertise as follows:
“Lack of expertise in accounting for share based pay indicates poor internal controls at the financial reporting level. There may be further complex transactions, such as derivatives, which have not been recognised.”
c. There may be an incentive for fraudulent financial reporting. In the scenario above, the incentive is the share-based pay scheme. Thus, we could write: “The share-based pay scheme is an incentive for management to overstate profit in order to maximise the share price. There is a risk for example that liabilities may be understated or assets overstated”.
2. The balance or transaction level: What does this mean? It means that individual balances, such as inventory, or transactions such as revenue, may be under- or over-stated. Why?
Generally, because they are COMPLEX or JUDGEMENTAL. This is where you must use your financial reporting knowledge in your explanations (remember that you should only study AAA after completing SBR or P2). If we consider the two issues raised by Dionne at the meeting:
a. Share based pay. Think about the accounting (debit expense and credit equity). Remember that the fair value of the instrument has to be calculated by an expert, and that the accounts preparer must form a judgement about the number of options that will vest. Thus: “Risk of mis-statement of share-based pay expense in the profit and loss and equity in the statement of financial position, because the calculation of the fair value of the instrument requires expertise and the calculation of the number of options expected to vest is subjective.”
b. Redundancies. Where have we met accounting for redundancies? When we studied provisions. Think about the accounting (debit expense and credit provisions). It would be very tempting to ‘knowledge dump’ because this is a much easier accounting standard to understand.
But what we need to do is to focus on the complex (calculation of redundancy payments) and the judgemental (redundancy payments will be an estimate). So: “Risk of mis-statement of provisions and the related expense because the calculation of the liability will be complex and will inevitably involve judgement.”
What should you do now?
Review the model answers to a couple of past AAA questions asking for audit risk – try to identify the risks at the financial statement level, and think about what might be complex or judgemental at the balance or transaction level.
When reviewing the model answers you may find it helpful to make notes on the types of risk identified.
• Steve Widberg is a freelance tutor