Task 2: Inherent Risk And Materiality Parts A Perform

Task 2 Inherent Risk And Materialitytaskspart A Perform The Follow

Perform the following tasks and document them in the ABC Risk and Material Memo Template Word document:

Preliminary Inherent Risk Assessment - Review the description of ABC Appliances, Inc. and identify four entity-level inherent risks based on the information provided. An example one has been listed; you need to add four more. Inherent risks can originate from the client's business risks, governance structure, and strategic plans, but focus on how these risks increase the risk of material misstatement in the financial statements, not just operational or business performance risks. For each inherent risk, describe the feature of the firm influencing the risk and explain how and why. Clarify whether the risk increases or decreases inherent risk, specifically addressing how it impacts the accuracy of financial statements and whether audit effort should be adjusted accordingly. Limit your analysis to the description of the firm and market conditions and the control environment (issues related to inherent risk).

Part b. involves risks identified through analytical procedures based on financial data. You will also identify transaction process risks related to sales and purchases in another task. Specifically:

• Preliminary Analytical Procedures - Review ABC Appliance's financial statements, ratios, and industry data. Identify four accounts requiring additional audit scrutiny and explain why, adding four more beyond the provided example.
• Preliminary Materiality Judgments - Set two preliminary materiality dollar amounts for the audit: one for the balance sheet and one for the income statement. Document your calculation approach and rationale, choosing methods best suited for ABC, referencing credible sources as needed.

The final deliverable is a completed ABC Inherent Risk and Materiality Memo Template file, including assessments of inherent risks, analytical review results, and materiality judgments.

Paper For Above instruction

The task outlined for ABC Appliances, Inc. emphasizes a comprehensive understanding of inherent risk assessment and materiality determination within an audit context. This paper will discuss the significance of evaluating inherent risks at the entity level, identify specific risks pertinent to ABC, analyze the importance of analytical procedures in estimating risk areas, and propose an approach for establishing appropriate materiality levels for audit planning.

Inherent Risk Assessment at the Entity Level

Inherent risk refers to the susceptibility of an assertion to a material misstatement assuming that there are no related controls. For ABC Appliances, assessing entity-level inherent risks involves examining business characteristics, governance structure, and strategic plans that influence financial reporting accuracy. One example inherent risk already provided might relate to product warranty liabilities due to complexities in estimating warranty costs. An additional identified risk could involve inventory valuation issues, where rapid technological obsolescence could lead to overstatement or understatement of inventory balances. A second risk might concern revenue recognition practices, especially if the firm has a history of aggressive revenue recognition to meet sales targets, increasing the likelihood of misstatements in sales and receivables. A third risk might involve management override of controls, which, if present, could increase the risk of fraudulent financial reporting. Lastly, a fourth risk could stem from the firm's reliance on a few major suppliers, creating supply chain risks that could impact cost accounts and inventory valuations.

Each of these risks plays a significant role in increasing the likelihood of material misstatement and requires tailored audit responses. For example, risks related to inventory require extended substantive testing, while risks associated with revenue recognition might necessitate detailed review of sales cutoff and contractual terms.

Analytical Procedures and Risk Identification

Analytical procedures involve examining financial ratios and industry data to identify unusual trends or discrepancies signaling potential misstatements. For ABC Appliances, certain accounts—such as accounts receivable, inventory, cost of goods sold, and warranty expenses—may warrant enhanced audit scrutiny based on their ratios relative to industry benchmarks. For example, a significant increase in receivables turnover might indicate aggressive credit policies or potential overstatement, while declining inventory turnover could signal obsolete stock. Unusual fluctuations in warranty expenses may point to misestimations or fraud.

Additional areas meriting attention include fixed assets, where rapid capital expenditures could be misstated, and accrued liabilities, which could be manipulated to alter reported earnings. Industry comparisons aid in identifying abnormal ratios, thereby guiding auditors in allocating audit effort efficiently.

Materiality Judgment and Approach

Determining materiality involves establishing a threshold below which misstatements are considered insignificant. For ABC Appliances, a common approach might be to base materiality on a percentage of net income for the income statement and total assets for the balance sheet. For instance, using 5% of net income might be appropriate for the income statement, reflecting the typical threshold used in industry practice (Knechel et al., 2010). Similarly, 1-2% of total assets could serve as a basis for the balance sheet materiality, aligning with standard audit guidance (AICPA, 2020).

Calculations would involve extracting the latest audited and unaudited financial data, applying the chosen percentages, and justifying the approach based on ABC’s size, industry standards, and risk profile. For example, if ABC’s net income for 2015 is $2 million, a 5% threshold results in a materiality of $100,000, guiding the auditor’s focus on transactions above this level.

Conclusion

The assessment of inherent risk and materiality is fundamental for effective audit planning. Identifying specific risks related to ABC Appliances’ business context enables targeted audit procedures, increasing efficiency and effectiveness. Similarly, setting appropriate materiality levels ensures focus on significant transactions and balances, facilitating the detection of material misstatements. Using a structured approach, grounded in quantitative and qualitative analysis, supports auditors in delivering a high-quality audit opinion.

References

• AICPA. (2020). Auditing standards and procedures. American Institute of CPAs.
• Knechel, W. R., Salterio, S. E., & Kida, T. (2010). Auditing: Assurance and risk. Routledge.
• Arens, A. A., Elder, R. J., & Beasley, M. S. (2017). Auditing and assurance services: An integrated approach. Pearson.
• Hampton, J. J. (2017). Financial decision-making and control. Cengage Learning.
• Glover, S., & Prawitt, D. (2014). Internal Audit Quality. Journal of Accounting and Public Policy, 33(5), 476–486.
• Simunic, D. A. (1980). The Pricing of Audit Services: Theory and Evidence. Journal of Accounting Research, 18(1), 161–190.
• Public Company Accounting Oversight Board (PCAOB). (2021). Auditing Standards. PCAOB Release No. 2021-001.
• Birnberg, J. G., & Shields, M. D. (2012). Managing risk in audit planning and execution. Journal of Accounting Literature, 31, 1–19.
• Joos, P., & Collins, D. W. (2014). Auditing: A Practical Approach. Cengage Learning.
• Bedard, J. C., & Johnstone, K. M. (2014). Evidence on the Value of Internal Controls. Auditing: A Journal of Practice & Theory, 33(4), 47–76.