Audit Risk Model and Assessment of Engagement Risk

by | Jan 20, 2024 | Accounting

 

SCENARIO
You work as an audit senior for a national CPA firm and have been assigned to audit the revenue cycle of the company’s 2020 calendar year-end annual financial statements. You work out of the Las Vegas, Nevada, branch office and are very familiar with the manufacturing and the gaming industry. The audit client, KMHS Manufacturing Company Inc., has been an audit client of your firm for the last three years, but this will be the first year you have worked on the engagement. During the brainstorming session held prior to fieldwork, the audit partner noted that that the company was having financial difficulties due to reduced revenue as a result of a global pandemic. An emphasis was added to the audit for the team to carefully consider management override.
KMHS began operations on January 1, 2005, in Las Vegas. The company is a nonpublicly traded, closely held S corporation with three shareholders: the CEO, who owns 40% of KMHS: the COO and general manager, who owns 35%; and the CFO, who owns 25%. The shareholders chose Las Vegas for the central location to casinos on the West Coast, low risk for natural disasters, and favorable gaming outlook by the banking industry. The three shareholders have 75 years’ experience between them in the gaming industry. The shareholders invested $1.4 million into the company when it began operations (see the attached “Appendix C: Financial Statements”). There are no related party transactions.
The company sales are classified under two groups: commercial customers and individual consumers. The company sells three products: casino chips (chips), dice, and playing cards (cards). Sales of chips, dice, and cards to commercial operations are conducted through KMHS’s Sales Department. The company’s final revenue stream is through slot machines (see the attached °Appendix A: Products, Sales, and Revenue” and “Appendix B: Customers, Warranties, Economic Conditions, and Accounts Receivable”).
During 2005, KMHS negotiated a $1 million bank loan to cover development of casino chips. In addition, it negotiated a $1 million line of credit. During 2012, the company negotiated an additional bank loan to cover the production of slot machines. In 2019, the company then negotiated a consolidated loan to finance production costs for dice technology. The negotiated loan required KMHS shareholders to add additional capital to lower the debt-to-equity ratio to no greater than 0.8%. The bank loans are collateralized by all the assets of the company and are guaranteed individually by the shareholders. Average interest rates for 2020, 2019, and 2018 were 6.0%, 6.0%, and 4.5%, respectively.
A. Describe the purpose of the audit risk model and explain the relationship between eachcomponent. Use the scenario and the attached Appendixes A-F to complete the following
B. Assess the engagement risk (auditor business risk) at high or low. based off the attached “Appendix D: Client Business Risks.” Justify your response using three or more aspects from Appendix D.
C. Address the following risks related to the revenue cycle:
1. Assess inherent risk for the revenue cycle at high or low. Justify your response using three ormoreaspects from the attached “Appendix E: Inherent Risks—Revenue and Accounts Receivable:
2. Assess control risk for the revenue cycle at high or low. Justify your response using three ormoreaspects from the attached “Appendix F: Control Risks and Internal Controls Walkthrough:
3. Determine whether the risk of material misstatement is high. moderate. or low based on your response in parts C1 and C2. Justify your response.
4. Set and interpret the desired level of audit risk at 1% or 5%. based off your response in part C3.
5. Determine whether the detection risk is high. moderate. or low based off your responses in parts C3 and C4. Justify your response.
D. Based off your responses in parts C1-05. determine an approach to obtaining audit evidence for each of the following assertions. including the percentage of tests of details. analytical procedures. and tests of controls. Justify your responses using the attached “Appendix F: Control Risks and Internal Control Walkthrough”:
1. existence/occurrence
2. completeness
3. valuation
E. Acknowledge sources. using APA-formatted in-text citations and references. for content that is quoted. paraphrased. or summarized.

 

Sample solution

Dante Alighieri played a critical role in the literature world through his poem Divine Comedy that was written in the 14th century. The poem contains Inferno, Purgatorio, and Paradiso. The Inferno is a description of the nine circles of torment that are found on the earth. It depicts the realms of the people that have gone against the spiritual values and who, instead, have chosen bestial appetite, violence, or fraud and malice. The nine circles of hell are limbo, lust, gluttony, greed and wrath. Others are heresy, violence, fraud, and treachery. The purpose of this paper is to examine the Dante’s Inferno in the perspective of its portrayal of God’s image and the justification of hell. 

In this epic poem, God is portrayed as a super being guilty of multiple weaknesses including being egotistic, unjust, and hypocritical. Dante, in this poem, depicts God as being more human than divine by challenging God’s omnipotence. Additionally, the manner in which Dante describes Hell is in full contradiction to the morals of God as written in the Bible. When god arranges Hell to flatter Himself, He commits egotism, a sin that is common among human beings (Cheney, 2016). The weakness is depicted in Limbo and on the Gate of Hell where, for instance, God sends those who do not worship Him to Hell. This implies that failure to worship Him is a sin.


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God is also depicted as lacking justice in His actions thus removing the godly image. The injustice is portrayed by the manner in which the sodomites and opportunists are treated. The opportunists are subjected to banner chasing in their lives after death followed by being stung by insects and maggots. They are known to having done neither good nor bad during their lifetimes and, therefore, justice could have demanded that they be granted a neutral punishment having lived a neutral life. The sodomites are also punished unfairly by God when Brunetto Lattini is condemned to hell despite being a good leader (Babor, T. F., McGovern, T., & Robaina, K. (2017). While he commited sodomy, God chooses to ignore all the other good deeds that Brunetto did.

Finally, God is also portrayed as being hypocritical in His actions, a sin that further diminishes His godliness and makes Him more human. A case in point is when God condemns the sin of egotism and goes ahead to commit it repeatedly. Proverbs 29:23 states that “arrogance will bring your downfall, but if you are humble, you will be respected.” When Slattery condemns Dante’s human state as being weak, doubtful, and limited, he is proving God’s hypocrisy because He is also human (Verdicchio, 2015). The actions of God in Hell as portrayed by Dante are inconsistent with the Biblical literature. Both Dante and God are prone to making mistakes, something common among human beings thus making God more human.

To wrap it up, Dante portrays God is more human since He commits the same sins that humans commit: egotism, hypocrisy, and injustice. Hell is justified as being a destination for victims of the mistakes committed by God. The Hell is presented as being a totally different place as compared to what is written about it in the Bible. As a result, reading through the text gives an image of God who is prone to the very mistakes common to humans thus ripping Him off His lofty status of divine and, instead, making Him a mere human. Whether or not Dante did it intentionally is subject to debate but one thing is clear in the poem: the misconstrued notion of God is revealed to future generations.

 

References

Babor, T. F., McGovern, T., & Robaina, K. (2017). Dante’s inferno: Seven deadly sins in scientific publishing and how to avoid them. Addiction Science: A Guide for the Perplexed, 267.

Cheney, L. D. G. (2016). Illustrations for Dante’s Inferno: A Comparative Study of Sandro Botticelli, Giovanni Stradano, and Federico Zuccaro. Cultural and Religious Studies, 4(8), 487.

Verdicchio, M. (2015). Irony and Desire in Dante’s” Inferno” 27. Italica, 285-297.

Sample Answer

Sample Answer

 

Audit Risk Model and Assessment of Engagement Risk

A. Purpose of the Audit Risk Model and Relationship between Components

The audit risk model is a systematic approach used by auditors to assess the overall risk of material misstatement in financial statements. It helps auditors determine the appropriate level of assurance required and the extent of audit procedures necessary to reduce audit risk to an acceptable level.

The audit risk model consists of three components: inherent risk, control risk, and detection risk.

Inherent Risk: Inherent risk refers to the susceptibility of an assertion to material misstatement before considering any controls. It is influenced by factors such as the nature of the client’s business, industry conditions, complexity of transactions, and the competence and integrity of management. The higher the inherent risk, the greater the likelihood of material misstatement without considering controls.

Control Risk: Control risk represents the risk that a material misstatement will not be prevented or detected on a timely basis by the client’s internal controls. It is influenced by factors such as the effectiveness of the client’s internal control environment, the design and implementation of control activities, and the monitoring of controls. The higher the control risk, the greater the reliance an auditor places on substantive procedures.

Detection Risk: Detection risk refers to the risk that the auditor will not detect a material misstatement that exists in an assertion. It is influenced by the nature, timing, and extent of substantive procedures performed by the auditor. The lower the detection risk, the more assurance an auditor seeks to obtain through substantive procedures.

The relationship between these components can be described using the audit risk equation:

Audit Risk = Inherent Risk x Control Risk x Detection Risk

The auditor’s objective is to set the overall level of audit risk at an acceptably low level through a combination of assessing and addressing inherent risk, control risk, and detection risk.

B. Assessment of Engagement Risk (Auditor Business Risk)

Based on the information provided in “Appendix D: Client Business Risks,” the assessment of engagement risk for KMHS Manufacturing Company Inc. can be categorized as high. Several aspects contribute to this assessment:

Financial Difficulties: The company is experiencing financial difficulties due to reduced revenue caused by a global pandemic. This increases the risk of misstatements in financial statements as management may be under pressure to present a better financial position.

Banking Industry Outlook: While Las Vegas was chosen as a favorable location due to its positive gaming outlook according to the banking industry, it is essential to consider any potential changes in this outlook that could impact the company’s operations and financial performance.

Loan Agreements and Debt-to-Equity Ratio: KMHS has negotiated multiple bank loans and must maintain a debt-to-equity ratio no greater than 0.8%. The company’s ability to comply with these loan agreements and manage its debt levels may impact its financial stability and overall business risks.

Considering these aspects, it is reasonable to assess engagement risk as high for this audit engagement.

C. Risks Related to the Revenue Cycle

Inherent Risk Assessment for the Revenue Cycle: Based on “Appendix E: Inherent Risks—Revenue and Accounts Receivable,” the assessment of inherent risk for the revenue cycle can be considered high. Justifications for this assessment include:

Economic Conditions: The revenue cycle is influenced by economic conditions, and KMHS is facing financial difficulties due to reduced revenue caused by a global pandemic.
Creditworthiness of Customers: There may be increased creditworthiness risks associated with customers’ ability to pay their outstanding accounts receivable due to economic challenges.
Complex Revenue Recognition: The revenue recognition process for casino chips, dice, cards, and slot machines can be complex, increasing the potential for misstatements.

Control Risk Assessment for the Revenue Cycle: Based on “Appendix F: Control Risks and Internal Controls Walkthrough,” the assessment of control risk for the revenue cycle can be considered high. Justifications for this assessment include:

Limited Segregation of Duties: The small size of KMHS may result in limited segregation of duties within the revenue cycle, increasing the risk of errors or fraud going undetected.
Weaknesses in Internal Controls: The walkthrough indicates that there are weaknesses in internal controls, such as lack of independent checks on revenue transactions and inadequate reconciliation procedures.

Determination of Risk of Material Misstatement: Considering the high inherent risk and high control risk assessments for the revenue cycle, it is reasonable to conclude that the risk of material misstatement for this area is high. This implies that there is a higher likelihood of material misstatements existing in the financial statements related to revenue and accounts receivable.

Setting Desired Level of Audit Risk: Based on professional judgment, auditors typically set a desired level of audit risk between 1% and 5%. Given the high risk assessments in parts C1 and C2, a lower threshold for audit risk at 1% would be more appropriate. This means that auditors aim to provide a higher level of assurance in detecting material misstatements.

Assessment of Detection Risk: Considering that audit risk is composed of inherent risk, control risk, and detection risk, and given the lower desired level of audit risk set at 1%, detection risk should be considered low. This means that auditors should plan and perform substantive procedures with a higher level of scrutiny and precision to reduce detection risk.

D. Approach to Obtaining Audit Evidence for Assertions

Existence/Occurrence:

Tests of Details: The auditor can select a sample of sales transactions and verify them against supporting documents such as sales invoices, shipping documents, and customer orders.
Analytical Procedures: The auditor can compare current year sales with prior year sales, industry benchmarks, and budgeted figures to identify any significant fluctuations or anomalies.
Tests of Controls: The auditor can assess whether management has implemented effective controls over sales order processing and review documentary evidence supporting sales transactions.

Completeness:

Tests of Details: The auditor can select a sample of shipping documents or sales invoices and trace them to recorded sales transactions in the accounting system.
Analytical Procedures: The auditor can compare recorded sales with supporting documentation such as shipping documents or customer orders to ensure all sales have been accounted for.
Tests of Controls: The auditor can evaluate whether management has implemented controls to ensure all sales transactions are recorded accurately and completely.

Valuation:

Tests of Details: The auditor can review pricing policies, compare selling prices with cost data, and examine discounts or allowances granted to customers.
Analytical Procedures: The auditor can perform gross margin analysis by comparing gross profit ratios with prior years or industry averages.
Tests of Controls: The auditor can evaluate whether management has implemented controls over pricing decisions, discounts, or allowances granted to customers.

E. Sources Acknowledged

Sources used in this essay:

Appendix A: Products, Sales, and Revenue
Appendix B: Customers, Warranties, Economic Conditions, and Accounts Receivable
Appendix C: Financial Statements
Appendix D: Client Business Risks
Appendix E: Inherent Risks—Revenue and Accounts Receivable
Appendix F: Control Risks and Internal Controls Walkthrough

Please note that specific references or citations were not made within this essay as all information provided is based on hypothetical scenarios presented in the scenario description and accompanying appendices.

 

 

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