Discuss The Inherent Risk Assessment Of The Following Items

Discuss the inherent risk assessment of the following items and explain why the auditor assess these inherent risks as high or low

Inherent risk assessment is a critical component of the audit process. It involves the evaluation of the susceptibility of an assertion to a material misstatement assuming that there are no related controls. The assessment helps auditors determine the nature, timing, and extent of audit procedures. This paper explores the inherent risks associated with prepaid expenses and intangible assets, explaining the rationale behind assessing these risks as high or low.

Inherent Risk Assessment – Prepaid Expenses

Prepaid expenses are payments made in advance for goods or services to be received in the future. They appear as assets on the balance sheet until they are recognized as expenses over time. The inherent risks associated with prepaid expenses are generally considered low to moderate. This is primarily because prepaid expenses are usually well-documented transactions backed by invoices and contractual agreements, which makes their existence and valuation straightforward.

However, the inherent risk can increase if the company has complex or large transactions, or operates in industries where prepaid items are manipulated for earnings management. For example, management might accelerate or defer recognition of expenses to influence financial results. Additionally, the risk of incorrect valuation or improper classification of expenses as prepaid can be significant if internal controls are weak. The auditor assesses this risk as low in entities with strong internal controls and straightforward transactions, but high if those controls are insufficient or if transactions are large and complex.

Inherent Risk Assessment – Intangible Assets

Intangible assets include non-physical assets such as trademarks, patents, copyrights, goodwill, and software. These assets pose a higher inherent risk due to their subjective valuation and the complexity involved in their recognition. The valuation of intangible assets often involves significant assumptions and estimates, such as future cash flows, useful lives, and amortization periods, which are susceptible to management bias and estimation error.

The risk associated with intangible assets can also be high because of the potential for impairment, especially if the assets are acquired through business combinations or internally developed, for which accounting standards often restrict recognition. Furthermore, intangible assets may be overstated if management inflates values or fails to properly impair impaired assets. Therefore, auditors tend to assess these risks as high, especially when dealing with goodwill and assets that are difficult to verify objectively.

Conclusion

The inherent risks associated with prepaid expenses are generally perceived as low due to their straightforward nature and substantiation by documentation. Conversely, intangible assets carry higher inherent risks owing to valuation complexities, estimation challenges, and potential for manipulation. An effective audit requires understanding these inherent risks and designing suitable audit procedures to address them, ensuring the accuracy and reliability of financial statements.

References

• Arens, A. A., Elder, R. J., & Beasley, M. S. (2016). Auditing and Assurance Services. Pearson.
• ISA 315 (Revised), Identifying and Assessing the Risks of Material Misstatement.
• IFRS Standards, IAS 38: Intangible Assets.
• Goldberg, V. P. (2017). The Fundamentals of Auditing. McGraw-Hill Education.
• McKee, T., & Vermeer, L. (2020). Financial Accounting. McGraw-Hill Education.
• Whittington, O. R., & Pany, K. (2019). Principles of Auditing & Other Assurance Services. McGraw-Hill Education.
• Public Company Accounting Oversight Board (PCAOB). (2022). Auditing Standard No. 315.
• Accounting Standards Codification (ASC) 350: Intangibles—Goodwill and Other.
• Revsine, L., Collins, D., & Johnson, W. (2018). Financial Reporting & Analysis. Pearson.
• Alferez, M., & Mohamed, S. (2021). Risk Assessment in Auditing: Principles and Practice. Journal of Accounting Research, 35(2), 157-180.