Below is a checklist of the possible planning implications for the audit of business risk
- Is the control environment good?
- Does the management manage risk effectively?
- Is the accounting system adequate?
- Do any risks threaten the going concern status of the company?
- Do any of the risks have implications for cash flow?
- Is there a high risk of fraud – e.g. poor controls, management override, overwhelming ambition and arrogance in the chief executive?
- Are there related parties with different agendas?
- Is the business under threat of being taken over, with the risk of management misstating financial statements?
- Is there a risk of litigation against the company?
- Is there any risk of withdrawal of support by loan or trade payables?
Ultimately many of the audit risks come down to the following factors or a combination of them.
- Possible misstatements due to lack of controls. Recent company failures (often shortly after clean audit reports) have been caused by overvaluation of inventory under allowance for bad debtors etc.
- Working capital shortage leading to cash flow difficulties and technical insolvency, often due to expansion which has been rapid.
- Inappropriate accounting policies. These can often lead to overstatement of assets or understatement of liabilities.
- Suppression of liabilities
- Fraud by management
- Related parties’ transactions or activities
- Going concern appropriateness
- Computer failures
- Litigation or regulatory problems
Test Your Understanding
As manager responsible for prospective new clients you have visited Hard bridge Lorry Component Ltd which supplies a small range of components for lorry manufacturers. The chief executive and majority shareholder is Mr. Alfred and he has asked your firm to make a proposal for the company’s audit and other services.
During the initial meeting you have ascertained the following information:
- The company’s turnover has increased by about 30% a year for the last three years
- Mr. Alfred is a dominating personality who seems tireless and has limitless ambition
- The company has two major customers and a few small ones
- The largest customer has recently announced major expansion plans and Harbridge have already purchased additional land and have signed a contract for more building to increase production. You have read in The Daily Times that the customer’s expansion plans are viewed with some skepticism by the city which seems to doubt the company’s viability.
- Harbridge has borrowed heavily from its bank and a major repayment of the loan is due shortly. The company is already on its overdraft limit and has yet to fund the new building construction. Mr. Alfred is in negotiation with a Middle Eastern bank for further finance.
- Many of the company’s parts are sourced in a country with an exchange rate which is very favourable to the UK. The financial press has lately suggested that this rate may change in the near future.
- The company recently purchased a very large and very complex computer system to control all its affairs. Mr. Alfred admits that his admin staff (headed by his brother, who has recently returned from five years back packing abroad) does not really have the competence to run it properly.
- The company recently purchased a company jet aircraft which Mr. Alfred says he finds essential for visiting customers and suppliers. Mr. Alfred pilots the aircraft himself. He has just been to Miami where there are neither customers nor suppliers.
- Mr. Alfred admitted that the company had recently been issued with writs alleging that the company had breached a patent in one of its vital processes and that the company had failed to pay the sum due to a supplier. Mr. Alfred did not consider this as serious and said that failure to pay was because the new computer system had not agreed the amount due with the supplier’s statement
- The company has no formal management accounting system. The new computer system is supposed to remedy that but nothing has been done as yet.
- Mr. Alfred has plans to float the company in the near future.
(a) Identify and describe the principal business risks relating to Harbridge Lorry Components ltd.
(b) Justify an appropriate audit strategy for the first audit of Harbridge Lorry Components Ltd.
(c) Suggest some procedures that Harbridge could implement immediately to improve is accounting procedures and financial controls.
Business risk is the risk that the audited entity will fail to achieve its objectives. This approach is said to offer a top down, rational, value added, focused and economical audit with good coverage of audit work. The business risk approach is to be preferred because it should result in a more efficient and focused audit performance by a more knowledgeable auditor resulting in a better auditor client relationship.