Identifying and Assessing Audit Risk Blue &Green Chartered Accountants has just
ID: 2508831 • Letter: I
Question
Identifying and Assessing Audit Risk
Blue &Green Chartered Accountants has just been appointed the external auditor for Orange Ltd.
Tom Brown is the Audit Senior for the new client and is in the process of planning the audit for the year ended December 31, 2016. He is currently performing risk assessment procedures to identify and assess the risk of material misstatement for further development of the audit procedures to ensure that the requisite audit evidence is obtained.
Background Data
Orange Ltd is a public limited company which was incorporated on June 1, 2000 as a motor insurance business. Its primary activity is the provision of motor insurance in return for a premium and its main expenses are Operating Expenses, Claims Expenses and Payroll Costs. The company’s major assets are Fixed Assets and Investments and its major liability is Outstanding Claim Settlement.
The Managing Director is connected to the Chairman of the Board of Directors by marriage and is paid a 40% share of profits in addition to a fixed salary. The criteria for profit pay is that the company must achieve a 25% Return on Investment; the other companies in the industry make an average ROI of 10%.
The following issues were extracted from the respective sources noted:
Review of previous year financial statements and discussion with previous auditors
There is a concern that the fair value of a commercial building owned by the company is materially overstated as the building which is currently unoccupied is in an area which has become rundown
The Provision for Outstanding Claims is deemed to be understated as based on the tests done the level of provision on a case to case basis is understated
Review of the Management Letters from the previous auditors
The procedure to review balances due from a customer on a periodic basis to assess collectivity has not been effective as it was discovered that the supervisor was not doing the review as required
The procedure to review Claims and make a provision based on an assessment of liability was not applied consistently, especially in the case of bodily injury which were the higher cost claims. The Managing Director had given directives to ensure that provisions were kept as low as possible.
The Managing Director authorized the write off of a material amount from Deferred Tax Liability which was unsupported.
Analytical review of current financials against prior year
2016
2015
% Change
$’000
$’000
INCOME / (EXPENSES)
Premiums
5,771,000
5,858,000
?
Operating Expenses
(2,323,000)
(2,397,000)
?
Claims Expenses
(3,710,000)
(3,843,000)
?
Payroll Costs
(880,000)
(680,000)
?
Investment Income
856,000
851,000
?
Net Income
2,088,000
940,000
?
ASSETS/ (LIABILITIES)
Fixed Assets
941,000
1,064,000
?
Investments
11,383.000
10,577,000
?
Outstanding Claim Settlement
(8,483,000)
(8,795,000)
?
Shareholders’ Equity
(6,088,000)
(4,993,000)
?
RATIOS
Net Margin
?
?
?
Return on Investment
?
?
?
On the social scene it was the talk that the Managing Director had deposited funds on a property in a high-scale community and that he was awaiting profit-share to pay off the outstanding amount.
Tom is a bit concerned that the level of audit work required will far exceed the cost for the audit. He has to be thinking of ways and means by which he can cut down the work. He hoped that the test of controls will allow him to reduce the level of testing.
Required:
Identify at least five (5) significant risk factors in the scenario above (5 marks)
State the type of risk for each risk noted in (1) above (5marks)
2016
2015
% Change
$’000
$’000
INCOME / (EXPENSES)
Premiums
5,771,000
5,858,000
?
Operating Expenses
(2,323,000)
(2,397,000)
?
Claims Expenses
(3,710,000)
(3,843,000)
?
Payroll Costs
(880,000)
(680,000)
?
Investment Income
856,000
851,000
?
Net Income
2,088,000
940,000
?
ASSETS/ (LIABILITIES)
Fixed Assets
941,000
1,064,000
?
Investments
11,383.000
10,577,000
?
Outstanding Claim Settlement
(8,483,000)
(8,795,000)
?
Shareholders’ Equity
(6,088,000)
(4,993,000)
?
RATIOS
Net Margin
?
?
?
Return on Investment
?
?
?
Explanation / Answer
Analytical review of current financials against prior year
2016
2015
% Change
$’000
$’000
INCOME / (EXPENSES)
Premiums
5,771,000
5,858,000
Decreases by 1.485 %
Operating Expenses
(2,323,000)
(2,397,000)
Decreases by 3.087%
Claims Expenses
(3,710,000)
(3,843,000)
Decreases by 3.460%
Payroll Costs
(880,000)
(680,000)
Increases by 29.41%
Investment Income
856,000
851,000
Increases by 0.5875%
Net Income
2,088,000
940,000
Increases by 122.12 %
ASSETS/ (LIABILITIES)
Fixed Assets
941,000
1,064,000
Decreases by 11.56%
Investments
11,383.000
10,577,000
Increases by 7.62 %
Outstanding Claim Settlement
(8,483,000)
(8,795,000)
Increases by 3.547 %
Shareholders’ Equity
(6,088,000)
(4,993,000)
Increases by 21.93 %
RATIOS
Net Margin
36.180 %
16.046 %
Increaes by 125.47 %
Return on Investment
99.25%
91.95%
Net margin = Net profit / Sales i.e premium
Significant Risk factors are –
Consequently , Investment costs may be overstated in the balance sheet and understatement of claims outstanding . This is for to show more investment so as to get investment income and profit both.
It is internal risk related to management of Company .Auditors has to focus on these point majorly..
Check whether the provisions is done on the basis of related policy and there is no understatement of liability.
It is type of liability risk company that ultimately result into profit.
Auditors has to find out to reflect true and fair financial position so to better reflection of claims.
It is financial risk.
And Tax liability will also get hit .
It is Startegic risk
Operational risk and related to management.
2016
2015
% Change
$’000
$’000
INCOME / (EXPENSES)
Premiums
5,771,000
5,858,000
Decreases by 1.485 %
Operating Expenses
(2,323,000)
(2,397,000)
Decreases by 3.087%
Claims Expenses
(3,710,000)
(3,843,000)
Decreases by 3.460%
Payroll Costs
(880,000)
(680,000)
Increases by 29.41%
Investment Income
856,000
851,000
Increases by 0.5875%
Net Income
2,088,000
940,000
Increases by 122.12 %
ASSETS/ (LIABILITIES)
Fixed Assets
941,000
1,064,000
Decreases by 11.56%
Investments
11,383.000
10,577,000
Increases by 7.62 %
Outstanding Claim Settlement
(8,483,000)
(8,795,000)
Increases by 3.547 %
Shareholders’ Equity
(6,088,000)
(4,993,000)
Increases by 21.93 %
RATIOS
Net Margin
36.180 %
16.046 %
Increaes by 125.47 %
Return on Investment
99.25%
91.95%
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