Question

When planning a financial statement audit, a CPA must understand audit risk and its components. The firm of Pack & Peck evaluates the risk of material misstatement (RMM) by disaggregating RMM into its two components: inherent risk and control risk.

Required:
For each illustration, select the component of audit risk that is most directly illustrated. The components of audit risk may be used once, more than once, or not at all.
Note if each illustration below is Control risk, Detection risk or Inherent risk
1. A client fails to discover employee fraud on a timely basis because bank accounts are not reconciled monthly.
2. Cash is more susceptible to theft than an inventory of coal.
3. Confirmation of receivables by an auditor fails to detect a material misstatement.
4. Disbursements have occurred without proper approval.
5. There is inadequate segregation of duties.
6. A necessary substantive audit procedure is omitted.
7. Notes receivable are susceptible to material misstatement, assuming there are no related internal controls.
8. Technological developments make a major product obsolete.
9. The client is very close to violating debt covenants.
10. XYZ Company, a client, lacks sufficient working capital to continue operations.

Answer 1

1. A client fails to discover employee fraud on a timely basis because bank accounts are not reconciled monthly. CONTROL RISK

2. Cash is more susceptible to theft than an inventory of coal. INHERENT RISK.

3. Confirmation of receivables by an auditor fails to detect a material misstatement. DETECTION RISK.

4. Disbursements have occurred without proper approval. CONTROL RISK

5. There is inadequate segregation of duties. CONTROL RISK.

6. A necessary substantive audit procedure is omitted. DETECTION RISK - 7. Notes receivable are susceptible to material misstatement, assuming there are no related internal controls. INHERENT RISK

8. Technological developments make a major product obsolete. INHERENT RISK

9. The client is very close to violating debt covenants. INHERENT RISK

10. XYZ Company, a client, lacks sufficient working capital to continue operations. INHERENT RISK.

Explanation:

Control risk.This means that client's Internal control systems are insufficient or inappropriate to detect or prevent material misstatements.

Detection risk. This means that audit procedures used are insufficient or inappropriate to detect or prevent material misstatements.

Inherent risk. This means that client's Financial Statement are susceptible to material misstatements.

Note if each illustration below is Control risk, Detection risk or Inherent risk

1. A client fails to discover employee fraud on a timely basis because bank accounts are not reconciled monthly. CONTROL RISK - The client's Internal control systems are insufficient or inappropriate to detect or prevent material misstatements

2. Cash is more susceptible to theft than an inventory of coal. INHERENT RISK. Cash by nature is more susceptible to theft than coal

3. Confirmation of receivables by an auditor fails to detect a material misstatement. DETECTION RISK. The audit procedures used are insufficient or inappropriate to detect or prevent material misstatements.

4. Disbursements have occurred without proper approval. CONTROL RISK - The client's Internal control systems are insufficient or inappropriate to detect or prevent material misstatements

5. There is inadequate segregation of duties. CONTROL RISK. The client's Internal control systems are insufficient or inappropriate to detect or prevent material misstatements

6. A necessary substantive audit procedure is omitted. DETECTION RISK - The audit procedures used are insufficient or inappropriate to detect or prevent material misstatements.

7. Notes receivable are susceptible to material misstatement, assuming there are no related internal controls. INHERENT RISK - Notes receivable by nature is more susceptible to misstatements

8. Technological developments make a major product obsolete. INHERENT RISK - Technological products by nature are highly subjective in valuation and are susceptible to valuation misstatements

9. The client is very close to violating debt covenants. INHERENT RISK - The client will be under pressure to make manipulate debt and equity figures, to paint a better picture with the financial statements

10. XYZ Company, a client, lacks sufficient working capital to continue operations. INHERENT RISK. the risk that the financial statements may not have been prepared under the correct assumption which is on 'break up basis', as this is a GOING CONCERN RISK, or whether the uncertainties of difficulty in raising funds, have been adequately disclosed in the financial statements.