Auditor Business Risk Case Study

Business risk is the probability that an auditor will suffer a loss or injury to his professional practice. It may also be defined as the risk that result from significant conditions, events, circumstances, actions or inactions that could adversely affect an entity’s abilities to achieve its objectives and execute its strategies. Risks are a natural part of the business, however, if not controlled they can jeopardize the operations of companies. There are various reasons that may result in a higher assessment of client‘s business risk. They include, overall economic climate, advanced technological change like when Apple’s new communication products affected the business of Nokia, competitor’s actions such as discounting prices and adding new product lines. The effectiveness of an entity’s internal controls can also affect client’s business risk by either preventing or detecting errors or intentional misstatements. Some of the examples that could indicate the existence of business risks are: significant changes in the entity such as large acquisitions, reorganisations; significant changes in the business in which the entity operates, significant new products or services, significant new lines of business, new locations, significant changes in the IT environment, operations in areas with unstable economies and high degree of complex regulation.
ALI Inc. was acquired fully by a Germany company and this indicates a business risk. After ALI Inc. was acquired by Bombardier, ALI Inc. was required to enter into contract with other companies to increase revenue. It failed to achieve this but did not inform Bombardier due to fear that Bombardier may discontinue their relationship with ALI Inc. or immediately lower the price and also insist refund of excess prices charged in the previous years. The loss of the manufacturing plant by ALI Inc. represents a threat to the existing business especially if the lost amount is not recovered from insurance company. ALI Inc. was able to recover at least 3 million. This may not be a threat to the business for now, but if the remaining amount is not recovered, it will pose a problem for ALI Inc. in the future. The insurance company offered to pay 5.1 million in settlement of the outstanding amount. The reduction in that amount could pose a threat of liquidity to ALI Inc.

Auditor’s business risk is the risk that the auditor is exposed to loss of professional practice from litigation, adverse publicity or other events arising in connection with financial statements audited. In other words, auditor’s business risk is the risk that the auditor will suffer harm because of a client relationship. Although the audit could be carried according to the generally accepted auditing standards (GAAS), the auditor will still be sued by the client. Some of the elements of auditor’s business risk are litigation and impaired professional reputation. Each of these elements may cause loss to a professional auditing practice in a variety of ways. For example, litigation can involve costs such as attorneys’ fees and court settlements. This could lead to ruined reputation resulting in loss of clients. Auditor’s business risk is can be controlled by the auditor. The auditor can influence auditor’s business risk, and thus engagement risk, through the selection of clients. Other factors bearing on auditor’s business risks, such as the client being involved in lawsuits, cannot be managed by the auditor. Regardless of the quality of work performed, involvement in future litigation may be inevitable when an auditor accepts or retains a client. There are several factors that have impact on auditor’s business risk. For example, auditors should consider the likely hood of a client filing for bankruptcy after the audit. If a client declares bankruptcy after an audit is completed, the likelihood of a lawsuit against the audit firm is reasonably high even if the quality of the audit was good.
The case of ALI Inc. shows an incidence where the auditor did not record investment acquired in the financial statements. Moreover, the auditor did not disqualify the audit report meaning that the financial statements did not portray a true fair view of ALI Inc. ALI Inc. can press charges against the auditor based on the information the auditor did not disclose. The new auditor should be concerned about the 47% investment acquired by ALI Inc. which was not reported in their financial statements. The outgoing auditor also did not qualify the audit report. The fact that auditors will not be able to access Exostar’s accounting system is a risk to the auditors because there is limited access to information. For an auditor to perform his duty effectively, he must have full access to information.

Audit Risk

Audit risk can be defined as the risk that the auditor gives a wrong audit opinion when financial statements are materially misstated. When an auditor decides on a lower level of acceptable risk, it means that the auditor wants to be more certain that the financial statements are not materially misstated. However, a high level of audit risk means that the audit firm is willing to take a higher risk of issuing an unqualified opinion on materially misstated financial statements. The auditor must recognize that once a client is accepted, audit risk cannot be eliminated. However, audit risk is determined and managed by the auditor and it can be reduced by doing more work targeted to specific areas where financial reporting risk is high.
Inherent risk is the risk that other accounting factors apart from internal controls will materially affect the financial statements. Therefore, inherent risk will be high where the levels of judgement and estimation are high or where the company’s financial transactions are complicated. Control risk is the risk that the misstatements will arise from poor internal controls. An example is where an organization hires a less qualified employee to handle complex work. The auditor should follow certain steps when using audit risk model. These steps are: determining the level of audit risk, determining the risk of material misstatement and using the audit risk model to find the level of detection risk.
In the case of ALI Inc. the inherent risk may be high because ALI Inc. was acquired by a host company whose goals are to maximize financial gains which is different from the goals of ALI Inc. The host’s business seems to be complex compared to ALI Inc.’s business and this may lead to the auditor making wrong judgement.

Managing Risks at client Acceptance

Before any audit firm takes up a client, it is important to perform several activities in order to make a decision of whether to take up the audit engagement or not. This helps the audit firm reduce its engagement risks. Once a client is accepted, the audit firm is exposed to an engagement risk. However, a low level of engagement risk is acceptable. In assessing the engagement risk, the auditor assesses the client’s and the auditor’s business risks and then plans the level of audit risk. The audit risk is managed by adjusting the nature, timing and extent of audit procedures while auditor’s business risk is controlled through the client’s acceptance decision process. The level of audit risk is adjusted in response to the risk factors noted during the acceptance or decision process. There is an inverse relationship between auditor’s business risk and audit risk. If an auditor assesses high auditor’s business risk, the auditor should not accept the client in order to avoid a high level of engagement risk. If the auditor assesses moderate auditor’s business risk, the auditor sets audit risk very low and hence a low engagement risk. If the auditor assesses low auditor’s business risk, it does not mean that he should perform fewer procedures in deciding whether to accept a client or not.
In ALI Inc.’s case, the greatest concern should be the investment that was purchased and not reflected in their financial statements. Another concern should be failure by the previous auditor to give a qualified report concerning the financial statements. The incoming auditor must assess the auditor’s business risk and make a decision whether to take up the engagement or not. In my opinion the incoming auditor should not take up the engagement with Ali because he must suffer the consequences of the previous auditor’s actions.

Materiality

Financial statements should portray a true and fair view as required by Financial Reporting Framework. An amount is considered to be material if it could reasonably be expected to influence the economic decisions of users of financial statements. Judgements about matters that are material to users of the financial statements are based on a consideration of the common financial information needs of the users as a group. The possible effect of misstatements on specific individual users, whose needs may vary widely, is not considered. Different categories have different materiality thresholds. For example, the materiality threshold of total assets is 0.3%, total revenue is 0.5% and equity is 1%. If an organization exceeds those limits, then audit risk could be high and the possibility of material misstatement could be high.
In the case of ALI Inc., the previous auditor set high materiality level. According to the information provided of total assets, the figure set is by far lower compared to the materiality level set by the auditor. The current assets are higher than the current liabilities which mean that ALI Inc. is able to cover its current liabilities and therefore it is not in financial difficulties.

Specific Accounting and Other Audit Issues

Specific accounting refers to accounting for certain entities whose accounting procedures differ slightly from the normal accounting procedures. In the case of ALI Inc., we know that it is a subsidiary of Bombardier. This means that at the end of the year, the financial statements of Bombardier will be a consolidation of ALI Inc.’s transactions and Bombardier transactions. Since ALI Inc. is acquired 100%, it has lost all the rights so it cannot independently prepare financial statements. All the activities done by ALI Inc. are a responsibility of Bombardier. Therefore, ALI Inc. must notify Bombardier about the clients they acquired. The 45% investment purchased by ALI Inc. will be reflected in the financial statement of Bombardier and it is Bombardier’s responsibility to account for that investment using the equity method of accounting.
Executive Summary of Aerospace Inc.