Essay: Audit Risk, Inherent Risk, And Control Risk In BlueCircle Chemicals Ltd.

It is 20^th May 2018.  You are an audit senior in the accounting firm ADG Partners.  You are currently planning the audit for BlueCircle Chemicals Ltd for their balance date of 30 June 2018.  You have been given the following documents:

• Memo from the audit engagement partner Kate Jones dated 17^th May 2018.
• Extract from the April 2018 issue of Business Review.
• Extract from the audit working paper for the previous year’s audit for BlueCircle Chemicals Ltd.

Required

1. Assess acceptable audit risk for the audit of BlueCircle Chemicals Ltd. (4 marks)

2. For the completeness assertion of the purchases account, answer the following questions in accordance with the Australian Auditing Standards. You need to perform your analysis using the facts in the case study.

a. Assess inherent risk.

b. Assess control risk.

3. For EACH of the ratios given by the engagement partner in the memo:

a. Identify whether the ratio has improved or declined.  What does this indicate?

b. State 2 follow-up audit procedures (for EACH ratio) you would perform to identify if there may be a potential misstatement in the financial information.

1. Auditing is conducted with the objective of providing an independent opinion on the financial reports of an entity. It is important to use appropriate analytical and substantive procedures during the course of auditing to express an appropriate opinion on the financial statements. The risk of expressing an inappropriate opinion on the financial reports can be described as the audit risk. Acceptable audit risk in an audit is the level of risk which an auditor considers acceptable to express an appropriate opinion on the financial reports. Generally, it depends on the entity, its environment, internal controls within the entity and securities (Glover, Prawitt & Drake, 2014).

The acceptable audit risk in the audit of Blue Circle Chemicals Limited is significantly low. This is because the company has number of weaknesses in the internal controls and securities. With inappropriate segregation of duties and responsibilities along with no separation of accounting department with other departments have ensured that the auditor assesses the acceptable level of audit risk for the audit of financial statements is very low. Hence, acceptable level of audit risk for Blue Circle Chemicals Limited is quite low. With lower the acceptable level of audit risk, the auditor must conduct extensive analytical and substantive audit procedures in the financial reports of the company to collect necessary audit evidence to express an appropriate opinion on the financial statements of the company (Chan & Vasarhelyi, 2018).

2. The components of audit risk can be segregated into three different elements, these are inherent risk, control risk and detection risk. The overall risk of an audit must be within the acceptable limits for an auditor to discharge his responsibilities properly.

Inherent risk is the risk of error, omission and commission in financial statements for reasons not related to the failure of controls within an organization. Such risk is mainly dependent on the nature of an entity, the nature of its transactions and its environment. Generally, an entity involved in complex financial and accounting transactions requiring to make complex estimates and provisions for different aspects of business operation will have high level of inherent risk. In contrast entities where transactions are regular and simple in nature, the inherent risk is significantly low (Brown-Liburd, Issa & Lombardi, 2015).

In case of Blue Circle Chemicals Limited the inherent risk for the audit of the company’s financial statements are explained below.

The company, i.e. Blue Circle Chemicals Limited is involved in purchase and sale of Chemicals carries out significantly simple transactions however, valuation of inventories of chemicals in hand is a significantly complex process requiring expert knowledge. The company has recruited comparatively less experienced and skilful personnel to record financial transactions in the books of accounts including valuation of its inventories. Thus, level of inherent risk will be adversely affected as a result of allowing a junior accounts clerk to do such important jobs (Plumlee, Rixom & Rosman, 2014).

Inherent Risk

The company has for the very first time has imported goods from a Thai supplier to reduce the purchase costs. Considering such transactions has never been affected before recording of these transactions correctly in the books of accounts is an important task. However, assigning the responsibility on the shoulder of a junior accounts clerk has significantly increased the inherent risk (Jans, Alles & Vasarhelyi, 2014).

The import from a Thai supplier are denominated in Thai Baht. These costs have to be translated in Australian dollar by using appropriate foreign exchange rate. AASB 121 must be followed strictly in translating the foreign exchange transactions using appropriate foreign exchange rate. The company has given the responsibility to translate foreign currency operations, i.e. to translate the cost of purchase from Thai supplier to a junior accounts clerk (Knechel & Salterio, 2016). Considering the knowledge and skills require for translation of foreign currency operations, using the junior accounts clerk services for such important aspect of financial inform ation has certainly increased the level oof inherent risk in the audit of the company.

The possibility of committing honest mistake by the junior accounts clerk is significantly high especially in translation of foreign currency purchase costs into Australia dollar. Thus, this has adversely affected the inherent risk in the audit of financial statements of the company (Power & Gendron, 2015).

The company has brought certain items from an organization owned by one of the directors of the company. Thus, the risk of related party transaction will increase the inherent audit risk of the company.

The company has not separated the accounting department with other departments. As a result the risk of fraudulent reporting is significantly high with coalition between accounting and other departments. Inherent risk in auditing of the company has increased due to non-separation of accounting and other departments of the company (Craig, 2017).

The accounting records if manipulated due to non-separation between accounting and other departments will lead to non-disclosure of true and fair picture of the company. Thus, the environment within the entity has significantly contributed in increasing the inherent risk level in the audit of financial statements of the company (Katz, 2015).

At the time of translating foreign transactions the accountants must use appropriate foreign exchange rates as per AASB 121. Complexity of accounting transactions has also played its part in increasing the inherent risk in the audit of financial statements of Blue Circle Chemicals Limited (Louwers, Ramsay, Sinason, Strawser & Thibodeau, 2015).

Control Risk

The overall inherent risk in the audit of the company is quite high as the company’s environment and nature of transactions have significantly increased the level of inherent risk for the audit of the company.

Internal controls and securities within an organization ensure proper reporting of financial information in financial statements. Lack of controls and weaknesses in these controls often lead to misreporting in financial statements. The control risk is the risk of misstatements in financial statements due to lack of controls and weaknesses in the controls within an organization.

The following aspects of internal controls and securities within Blue Circle Chemicals Limited has affected control risk in the audit of financial statements of the company.

The purchase manager of the company is only authorized to issue purchase orders thus, there is clear line of control in terms of issuance of purchase orders. Thus, the control in respect of issue of purchase orders is quite strong (Simnett, Carson & Vanstraelen, 2016).

A copy of the purchase order subsequent to its issue is sent to the accounting department. The accounting department checks the purchase order and record transactions in the books of accounts correctly. Thus, there is significant control till this stage of purchase orders.

The level of internal controls and procedures for issue and recording of purchase orders are quite strong thus, there is hardly any weakness till the stage recording purchase orders in the books of accounts (Arens, Elder, Beasley & Jones, 2015).

The invoices issued by the suppliers are not checked along with the purchase orders. Thus. In case there is any discrepancies between the purchase orders and the invoices sent by the supplier there is no internal; control to identify such discrepancies. Hence, there is huge risk in the internal control system within the organization.

Since there is no checking of suppliers’ invoices subsequent to the receipts of these invoices thus, in case there has been any mistake in the amount of invoices then the same will go unnoticed. The lack of internal controls will made it impossible to identify the errors in invoices and subsequently in the financial statements of the company (Marques, Santos & Santos, 2016).

The suppliers’ ledgers are reconciled by the junior accounts clerk create another potential internal control problem for the company. The control risk as a result of the above will increase significantly.

Since the accounting departments of the company are not separated from other departments, there is a huge risk of coalition between the accounting and other departments. As a result the risk of fraud committed by colliding with the staffs from different departments and to manipulate accounting records subsequently is significantly high. Hence, the internal controls within the company is not appropriate to reduce the control risks of the company to a low level (Hoyle, Schaefer & Doupnik, 2015).

Conclusion

The suppliers are directly paid by the accountants directly. This creates a huge control risk for the company. The accountants can easily manipulate the accounting records to show higher payments made to the suppliers to siphon off company’s funds.

Taking into consideration the above it is clear that the control risks within the organization is significantly high. Since both inherent and control risks in the company have been assessed as high. Hence, detection risk must be kept as low as possible to reduce the overall risks in the audit of the company to an acceptable level. 

In order to identify whether the ratios have improved or declined let us first have the table containing the ratios of the company for last three years:

Quick ratio is calculated by dividing quick assets of an organization with its current liabilities. This ratio shows the ability of an organization to pay off its current liabilities by using cash and accounts receivable balances. Quick ratio of 2017 has declined to 1.8 from 1.9 of 2016. However, the quick ratio of the company has improved significantly in 2018.

Inventory turnover ratio indicates the ability of an organization to use its inventories in earning revenue. The inventory turnover ratio for 2018 of Blue Circle Chemicals Limited has worsened significantly. The company needed 60 days in 2018 to turnover its inventories whereas it was merely 37 and 39 days respectively in 2017 and 2016 (Butler, 2016).

Days to collect account receivable of Blue Circle Chemicals Limited has again deteriorated with the company now needing 76 days to collect its accounts receivable in 2018 compared to 60 days in 2017 and 55 days for the industry average.

Gross profit ratio has showed a huge improvement to 24% in 2018 compared to negative gross profit margins of -19% and -18% in 2017 and 2016 respectively.

Follow up audit procedures:

1. To evaluate that the accounts receivable and cash have been correctly valued in the books of accounts. To ensure that bad debts and other debts not recoverable have been deducted in determining the value of accounts receivable used for calculating quick ratio.
2. Sudden increase in quick ratio in 2018 suggests that there must be significant increase in cash sales or in collection of accounts receivable. Both should be properly verified to ensure that these have been recorded correctly in the books of accounts.

1. Evaluation of inventory valuation technique used by the company.
2. Physical inventory verification by the auditor to ensure that the inventory value showed as per books of accounts is correct (Louwers, Ramsay, Sinason, Strawser & Thibodeau, 2015).

1. To check that all credit sales have been recorded correctly in the books of accounts of the company.
2. The bad debt has been correctly deducted in arriving at the net value of books debts.

1. The huge fluctuation in gross profit margin of the company, i.e. from (19%) to 24% in 2018. The reason for such huge improvement must be verified by the auditor.
2. The cost of goods sold valued by the company must be evaluated by the auditor to ensure that the gross profits have been correctly determined in the books of accounts.   

References:

Arens, A. A., Elder, R. J., Beasley, M. S., & Jones, J. (2015). Auditing: The Art and Science of Assurance Engagements. Pearson Canada.

Brown-Liburd, H., Issa, H., & Lombardi, D. (2015). Behavioral implications of Big Data's impact on audit judgment and decision making and future research directions. Accounting Horizons, 29(2), 451-468.

Butler, K. C. (2016). Multinational Finance: Evaluating the Opportunities, Costs, and Risks of Multinational Operations. John Wiley & Sons.

Chan, D. Y., & Vasarhelyi, M. A. (2018). Innovation and practice of continuous auditing. In Continuous Auditing: Theory and Application (pp. 271-283). Emerald Publishing Limited.

Craig, P. (2017). Formal and substantive conceptions of the rule of law: an analytical framework. In The Rule of Law and the Separation of Powers (pp. 95-115). Routledge.

Glover, S. M., Prawitt, D. F., & Drake, M. S. (2014). Between a rock and a hard place: A path forward for using substantive analytical procedures in auditing large P&L accounts: Commentary and analysis. Auditing: A Journal of Practice & Theory, 34(3), 161-179.

Hoyle, J. B., Schaefer, T., & Doupnik, T. (2015). Advanced accounting. McGraw Hill.

Jans, M., Alles, M. G., & Vasarhelyi, M. A. (2014). A field study on the use of process mining of event logs as an analytical procedure in auditing. The Accounting Review, 89(5), 1751-1773.

Katz, J. (2015). A theory of qualitative methodology: The social system of analytic fieldwork. Méthod (e) s: African Review of Social Sciences Methodology, 1(1-2), 131-146.

Knechel, W. R., & Salterio, S. E. (2016). Auditing: Assurance and risk. Routledge.

Louwers, T. J., Ramsay, R. J., Sinason, D. H., Strawser, J. R., & Thibodeau, J. C. (2015). Auditing & assurance services. McGraw-Hill Education.

Marques, R. P., Santos, H., & Santos, C. (2016). Evaluating information systems with continuous assurance services. International Journal of Information Systems in the Service Sector (IJISSS), 8(3), 1-15.

Plumlee, R. D., Rixom, B. A., & Rosman, A. J. (2014). Training auditors to perform analytical procedures using metacognitive skills. The Accounting Review, 90(1), 351-369.

Power, M. K., & Gendron, Y. (2015). Qualitative research in auditing: A methodological roadmap. Auditing: A Journal of Practice & Theory, 34(2), 147-165.

Simnett, R., Carson, E., & Vanstraelen, A. (2016). International archival auditing and assurance research: Trends, methodological issues, and opportunities. Auditing: A Journal of Practice & Theory, 35(3), 1-32.