Inherent risks: Key to an efficient auditing process?

Published: Last Edited:

This essay has been submitted by a student. This is not an example of the work written by our professional essay writers.

The efficiency of audit process can be improved with the ability to assess inherent risk. Inherent risks are the first one which is dealt by the auditor. Inherent risk is the risk which initiates from the susceptibility of misstatements occurring in the account balances or transactions. Assessment of inherent risk enables the auditor to adopt and apply better control procedures. Current techniques enable the auditors to form an overall judgment and assessment of the inherent risk at each account balance at every level. Assessment of the inherent risk makes the auditor conservative and reduces the inherent risk to about 50% but assessment of inherent risk is time consuming in normal circumstances and it will become more complicated and time consuming in such corporation or firms where organizational and management structure is complex and transactions are complex (Graham, 1999)

The present case study indicates the existence of inherent risks and the first inherent risk in the financial statements of Nurotab Pty Ltd (NPL) is cost associated to the research and development. The cost associated to the research which is charged to the income statement of NPL is not clearly mentioned and there is a probability that management underestimate the research cost charged to the income statement which overstate the profits of the NPL to achieve the targeted profit and it may also be probable that research cost is overstated to cover the amounted forfeited by the management or executives or research manager and this forfeited amount is adjusted against any secret payment of penalty or any other matter which affects the goodwill of the corporation (Gibbs J. & P. Keating, 1995).

Second inherent associated with the financial statements of the NPL is misstatement of the sales figure or overstating the amount of receivables which in turn improve the profits, profitability, liquidity and solvency ratios of the corporation. The existence of this risk in the financial statements of the NPL can be estimated form the larger portion of its export sales billed in the respective currencies of the buyer countries. Export sales are difficult to trace as per the values mentioned in the invoices because it is oftenly done with the help or collaboration of the buyer. Based on the overstated value of sales figure enables the exporter i.e., the NPL to claim tax credit on sales and importer i.e., the buyer of the drugs can claim input tax credit on overstated figures. Online local credit sales comprise of 25 % of the total sales of the NPL which creates the suspicion of the sales figures due to the reason that it is credit sales and the sales transaction is done through online channel of the company. With online channel of sales transaction, sales figures can be misstated to achieve various objective of the management such as achievement of target profits and higher rate of bad debts which reduces the net profit resulting tax evasion (Grambling A. & D. Stone, 2000).

Third inherent risk is the inexperience of the newly appointed Chief Executive Officer and Chairman of the Board who is appointed just few days back and immediately after his appointment he has initiated review of operations and has decided to adopt new accounting and reporting software which has been used in the parent company. During the period of change management personnel who are authorized for implementing the change in the corporation are given direct physical access to the accounts which are not been provided to them previously and they can manipulate the records during the period of change and they can hide any misstatements and discrepancies in the accounts. There is a possibility that management is against the decisions taken by the CEO and they manipulate the records and accounts balances to fail the implantation of new accounting and reporting software (Gibbons, M. and C. Emby, 1984).

Significant change of conditions in the industry in which the corporation or the firm operates gives rise to the presence of inherent risk in the financial statements of the firm. NPL's industry conditions also change substantially after lifting export tariff competition in the drug industry will increase and management can misstate or manipulate the account balances to beat the rivals.

Inherent risk also exists when the management is under pressure to provide the target or expected results. In the situation of NPL, Mr. Fiddlit new CEO is appointed just few days back and he has a reputation of giving results. His term of CEO ship for next three years is based on the results provided and the management of the parent company is expecting a lot from him. He is senior most in the hierarchy of management and his pressure will be transmitted throughout the management to give the expected results and this pressure can compel the management to misstate the account balance to achieve their targets as expected. The expectation of management of the parent company is high from the CEO of the NPL as 10% increase in profits every year for the next three years which is very hard to achieve and maintain (Helms, G. L., 1999).

Sixth inherent risk also exists when the integrity of the management is impaired, and it is proven in the credit section of the NPL where its former credit has misappropriated the cash and didn't process the credit accounts timely. This has caused serious misstatements and manipulations in the accounts of NPL in order to conceal the cash forfeited and mishandling of credit accounts. Current officer Mr Holler is working on it with the help of internal auditors, this fraud and concealment of facts have indicated that NPL's internal control are ineffective and its new credit officer is inexperienced as he was appointed for this seat just six month before. There is no indication from the management that they have changed the way of doing job of handling credit accounts and also they have not developed any mechanism for receiving cash from customers so that there is strong probability of happening the same case in future due to weak internal controls. Controls help and reduce the inherent risk to manageable lowest level and oftenly review, audit and risk committee continuously tried to improve the internal controls in order to avoid any misstatement or assertion of accounts balance (Kaplan, S. E. and Reckers, M. J., 1989).

Seventh inherent risk exists when the management use its own judgment for estimation of account balances and outcomes of different transactions instead of experts opinion or valuation from expert independent party for valuation of any account balances or assets which ensure the impartiality and true compliance of accounting standards and legislation of the country or region in which the entity operates. Fair values of assets are oftenly checked for impairment testing of assets and even also liabilities. NPL has also valued the fair value of its one of the assets that is the fair value of the factory and this valuation is done by one of the director of the board of directors. Directors are the first and major stakeholders of the NPL and sometimes they overstate the value of its assets to make the footings of the balance sheet as strong as much as possible. Overstatement of assets directly and significantly affects the accounting and evaluation ratios of the corporation and the financial statements of the firm or corporation appears much stronger than actually they are. Overstated assets sometimes justify the low profits after tax so that management can conceal their deficiencies and inefficiency and innocent stockholders can be deceived. Degree of inherent risk will increase to the greater extent when the assets are of such a nature that valuation of such assets cannot be done by the independent third party and there is no active market exist for that assets so that true valuation of the assets can be determined by comparing the value of similar assets traded freely in the active market. Valuation of plant, machinery or factory is very difficult task such as to check the obsolesce rate and degree of obsolesce cannot independently be determined. Sometimes the management is under great influence of one of the director of the board of directors and the valuation by that director cannot be questioned and argued by the management and they accept the whatever value determined of the asset. This practice is against the guidelines of corporate governance and the requirements of different accounting and financial reporting standards (Kennedy, J., Kleinmuntz, D., and M. Peecher, 1997).

Sometimes management misstates or understates the value of liabilities and more importantly current liabilities which significantly affect the working capital, liquidity and insolvency testing ratios. In this case of NPL, management has significantly reduce the current liability of the loan and argued that it is done in consultation and with the assent of the bank. If this fact is present in the financial statements of any corporation the chance of presence of inherent risk increases and this fact is proven in the financial statements of the NPL. In its disclosure it is proven that management has reduced the outstanding liability of secured loan significantly which in turn can increase the value of free assets. This practice is normally done when the corporation wants to issue new shares or to increase the market value of the existing shares. Freehold assets significantly increase the worth and ensure the strong financial position of the corporation. By doing such things management can made the corporation eligible for further borrowing.

The inherent risk also exist when the management such methods of costing which allocates overhead cost in such a way that which increase the profitability of the corporation with increased production and such appropriation and allocation of cost is not in accordance to the nature of the business and the product. They under invoice the material purchases or exclude some of the cost associated to the product or service in form of wages and fringe benefits or by applying lower rate of wages for calculating the labor cost (Kaplan, S. E., C. Moeckel, and J. D.Williams, 1992).

The inherent risk also exists when the value of some asset is significantly increases or when the asset or assets appear on the face of the balance sheet in the name of "Other Assets" which was not present in the comparative figure of previous year's balance sheet and also the amount or value of such asset is material. If any amount is material in the balance sheet of the corporation it has to be appeared on the face of the balance sheet with respective name and disclosure as per the requirements of the different accounting standards practicing in the world whether it is GAAP or IAS & IFRS. If any of the requirements of the respective accounting or reporting standard cannot be met then it is assumed and proved that account balance are misstated and it is not disclosed in the balance sheet as per the requirements and accounting treatment of the respective transaction. Deviation of accounting standards are allowed in only case where deviation is justified on the basis that fulfillment of the requirements of the accounting and reporting standards cannot be present the substance of the transaction and information disclosed will not represent the true and fair view of the transaction and the financial position of the corporation and this deviation will not be regarded for the evaluation of inherent risk (Manello, C. and W. Rocholl, 1997).

Cash and cash equivalent balances of the entity is the first target for the assessment of the inherent risk evaluation. Cash balances are most volatile and highly at risk to the misstatement and misappropriation in the financial statements of the entity. NPL's balances have reduced in the current year ended 31st March as compared to the closing balances of the preceding year. Amount of provision for uncollectable is oftenly charged less to increase the working capital and manipulating the financial statements of the company. NPL's provision should be tested and checked so this is included in the inherent risk of the company. NPL's management comprised of Australian managers except the Chief Executive Officer (CEO) who is not an Australian and this diversity may raise conflicts between the Chief Executive Officer and subordinate managers and the subordinate managers with intention of failing the policies of the chief executive misstate the account balances below the target levels.

Issues regarding Audit of NPL

In accordance to our auditing plan for the year 2009 - 2010, we are conducting the audit of Nurotab Pty Ltd (NPL) an Australian subsidiary of parent company of United States. Parent company has requested to address some accounting and reporting issues. Based on the results of testing by applying certain auditing procedures it is assessed that internal control of the NPL is weak. In addition to the weak internal control we have discovered some compliance issues regarding off balance sheet financing and other reporting issues. The information regarding issues is presented in two parts.

Scope and Objective

The scope of our audit includes financial transactions appear in the financial statements during the period of March 31st 2009 through March 31st 2010. Based on our preliminary observations some transactions are included and some are excluded from said period. We are focusing on the final account balances.

The objective of our audit was to determine the accuracy and compliance of financial transaction as per the requirements of concerned accounting and auditing standards and compliance of tax rules and regulations.


Our auditing procedures reviewing of documentation related to the tax guidance issued by the concerned tax authorities, management competence and reliability of the accounting and reporting software. We have selected various accounts, invoices and transactions for examination. We have made physical investigations and conduct inquires related to different doubts and suspicions.

Auditing Results

Based on our auditing results, we conclude that internal controls of NPL are weak which cause forfeited and misstatement of credit account balances and cash received. Reporting issues of different financial transactions existed in the financial statements for the period audited. Some of the vital issues are discussed below:

Finding: Reporting of leasehold warehouse building

After investigation of the lease agreement of Sydney warehouse building it is discovered that lease term of building is for 10 years and its useful life is 25 years and management has not any option of the buying at the end of the lease term, by considering all these facts this lease should be classified as off balance sheet financing or operating lease instead of finance or capital lease.

Management Action

Management of NPL is seriously considering our finding and they have started consultation with other exports and senior executives to sort out the issue raised.

Finding: Valuation of tangible assets

It is discovered from the audit outcomes that the valuation of tangible fixed asset i.e., the plant is determined by the director of the company which should have been done through independent export. So that it's true fair value can be determined reliably.

Management Action

Management has hired team of engineers to determine the useful life and fair value of the plant.

Other Comments

Internal auditors of the NPL are continuously improving the controls and management has plan to form audit and risk evaluation committee which ensures compliance of accounting and reporting standards for true and fair view of financial position of the corporation (F. Michael, 2006).