As Noted Below: Imagine That The Current Date Is December 5

As Noted Below Imagine That The Current Date Is 5 December 2017 The

Identify the risks present at GGI based on the case details, classifying each risk according to the engagement risk model. Then, assess the overall level of audit business risk (ABR), control risk (CBR), and audit risk (AR) separately on a scale of very low, low, medium, high, and very high, providing brief explanations for each assessment. Next, select one risk where management is departing from generally accepted accounting principles (GAAP), describe what management is doing wrong, and explain what they should have done instead, supported by relevant accounting standards. Additionally, identify a misstatement or likely misstatement in an account, along with the related management assertion that might be misstated, with a brief explanation. Assuming all risks are addressed and misstatements corrected, describe the type of audit report the auditor will issue, including the key features that inform this classification. Finally, identify the mistake made by the previous senior auditor in the interim testing strategy, explaining why it was an error.

Paper For Above instruction

The audit of Great Gifts, Inc. (GGI) involves numerous risks stemming from the company's operational environment, management attitude, and recent financial practices. Identification and assessment of these risks are fundamental in planning an effective audit approach. This paper explores these risks, their classifications within the engagement risk model, and evaluates how they influence the overall audit risk, control risk, and audit business risk. It also discusses specific instances where management has potentially departed from GAAP, the implications of such deviations, and the associated assertions possibly misstated. Furthermore, the expected nature of the audit report is considered given the assessed risks, alongside a critique of the prior auditor’s control testing strategy.

Risk Identification and Classification

1. Management’s optimistic earnings guarantees during conference calls. This poses a risk of misstatement due to potential pressure to meet targets, and potentially leading to premature revenue recognition or overstated income. Classification: Client Business Risk (CBR)

2. The departure of key executives (CEO, CFO, Controller). This increases engagement risk because the loss of experienced leadership can weaken internal controls and affect financial reporting quality. Classification: Engagement Risk (ER)

3. The unfilled Controller position and reliance on a staff auditor to manage internal controls. This elevates control risk because of potential gaps in oversight. Classification: Control Risk (CR)

4. The capitalization of $300,000 research costs as an asset. Since these are research expenses, capitalizing them may violate GAAP, creating the risk of financial misstatement. Classification: Audit Risk (AR)

5. The delay in roll-out of the new product line, leading to potential inventory obsolescence or impairment. This introduces risk related to accurate inventory valuation. Classification: Client Business Risk (CBR)

6. Changes in sales of traditional product lines, with management optimistic about year-end sales recovery. This can bias revenue recognition assumptions. Classification: Client Business Risk (CBR)

7. Problems with new software for accounts payable, including two material control weaknesses. This significantly increases control risk, raising concern about processing accuracy. Classification: Control Risk (CR)

8. The December 2017 revenue recognition of $400,000 for a Valentine's Day order scheduled for January 2018. This entails a risk of premature revenue recognition, potentially overstating income. Classification: Audit Risk (AR)

9. The reduction in the allowance for doubtful accounts from 3% to 0.5%. If unsubstantiated, this adjustment could lead to overstated receivables and income. Classification: Client Business Risk (CBR)

10. Reversal of inventory impairment to income, initiated by the CEO. This could lead to overstatement of inventory and net income if not properly supported. Classification: Engagement Risk (ER)

Assessment of Overall Risks

- Audit Business Risk (ABR): High: The company faces substantial market and operational uncertainties, including management’s aggressive earnings guarantees, the recent loss of experienced leadership, and ongoing operational challenges. These contribute to high overall business risk, influencing the likelihood of financial misstatement and operational failure.

- Control Risk (CBR): High: Significant internal control weaknesses have been identified, particularly regarding the new software implementation and the reliance on management’s judgments for impairments and inventory valuation. The lack of a dedicated internal audit department further elevates control risk.

- Audit Risk (AR): High: Given the combined impact of control weaknesses, management’s aggressive accounting policies (e.g., capitalization of research and inventory adjustments), and potential earnings management strategies, the overall audit risk remains high, necessitating extensive substantive procedures.

Management Departures from GAAP and Corrective Recommendations

One prominent departure involves the capitalization of research costs of $300,000 as an intangible asset. Under GAAP (ASC 730), research and development costs should be expensed as incurred, not capitalized, unless they meet specific criteria that explicitly allow capitalization. Management's treatment essentially contradicts GAAP standards, which require such costs to be recognized as an expense in the period incurred. Instead, management should have expensed the research costs immediately, which would have resulted in lower assets and net income in the current period, more accurately reflecting the economic realities of R&D expenditure.

Misstated Account and Management Assertion

Inventory is a potential account that can be misstated, especially considering the reversal of the previous year's impairment. The management assertion most at risk here is Valuation and Allocation. The company’s belief that obsolete inventory will be sold due to economic strength could lead management to overstate inventory value. If inventory is not properly reviewed for obsolescence and its carrying amount is not supported by actual marketability or realizable value, then inventory could be misstated, leading to overstatement of assets and net income.

Expected Audit Report

Given the high levels of risk and control deficiencies, the auditor is likely to issue a Modified Audit Report – Qualified or Adverse. If the control weaknesses are significant enough to prevent the auditor from obtaining sufficient appropriate audit evidence regarding internal controls, a Limited Assurance or Adverse opinion on internal controls might be issued. Additionally, if material misstatements are identified and cannot be corrected, the auditor would issue a Qualified or Adverse opinion on the financial statements, depending on the severity of misstatement.

Bonus: Control Testing Strategy Mistake

The previous senior auditor’s decision to test controls over payables and purchases at interim was flawed because of the presence of material control weaknesses. Testing controls under ineffective processes, especially shortly after implementation and during periods of management change, is unlikely to yield reliable results. It was a mistake because controls were not stable or fully operational, increasing the risk that testing would provide a false sense of security. A better approach would have been to perform control testing at year-end when controls could be observed in operation during a longer period or to increase substantive testing to compensate for control deficiencies.

References

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