Describe about the Auditing Theory and Practice for Business Organizations.
Risk is the situation under which organisation is exposed or vernacular to certain and uncertain danger present in internal and external environment. Woolworths Limited is the organisation which is undertaken for this report. In this report, inherent risk factors are discussed and how identification of same is done by auditor of the business organisation. On what basis, identified risk is can because material misstatement in the financial statements was also discussed in this report (Batta, Ganguly & Rosett 2914). Inherent risk can be defined as the risk which exists in business because of environment and lack of control measures.
Following are four inherent risk factors that Woolworths Limited has in its financial statements:
Inherent Risk Factor 1: Market Risk – Rapid change in exchange rates
Describe the risk- Rapid change in exchange rates is the most crucial inherent risk factor that Woolworth ltd has. Since Woolworth ltd has its business operations all around the globe and operating its business in many different countries. This raises the concern of exchange rates and fluctuation in different currencies (Djassemi 2012).
How risk create material misstatement in financial statements- Operating profits of Woolworth ltd can be seriously influenced from exchange rate different as sales revenue comes from different countries and at different point of time. Therefore audit plan of auditors shall include due consideration of Rapid change in exchange rates as inherent risk factor. Therefore in this manner, rapid fluctuation in exchange rates will influence income statement of Woolworth ltd. On the other hand, operating exposure to exchange rate fluctuation can made impact on financial statements as there are many foreign competitions in the market (Hasanov & Baharumshah 2014). Woolworth ltd can face influence of inflation rate of different economy or countries on its sales revenue. Impact of exchange rate can either increase profitability or it can decreases profitability of Woolworth ltd. While auditing the financial statements of Woolworth ltd, auditors needs to make detail analysis of exchange rates and correct reflection of same while recording transactions in financial statements (Jans, Alles & Vasarhelyi 2014).
In this case of Woolworth ltd, accuracy assertion plays important role while auditing financial statements. As per accuracy assertion, transaction undertaken by Woolworth ltd shall be recorded at appropriate amount. Here appropriate amount means, exchange rate shall be correctly used while converting foreign current into home currency (Clikeman & Diaz 2014). Therefore this has became most curtail area of concern for auditors that to check exchange rate at the time of transaction and other relevant adjustments had been made or not. Another assertion that shall take place while making audit plan is of classification. Classification assertion requires correct and appropriate classification and presentation of foreign transactions undertaken during the period in financial statements (Mainardi 2011). Profit or loss on foreign exchange transactions has been appropriately classified or not and fairly presented or not need to be check by auditor.
Therefore while making audit plan inherent risk of rapid change or fluctuation in exchange rates shall be examined and verified by employing classification and accuracy assertions.
Inherent Risk Factor 2- Critical Accounting Estimates and Judgements
Describe the risk
Another form of inherent risk that Woolworth ltd faces is of critical accounting estimates and judgements that managers and board of directors has to make time to time. Since business operation of Woolworth ltd has spread out in various sections therefore they are exposed to more inherent risk as propionate to business operations. While complying with group’s accounting policies and business assumption, managers at different level and directors have to certain adjustment and estimates of amount that are presented in financial statements of Woolworth ltd. Accounting estimates, assumptions and judgements made by directors or mangers are based on their working experience, level of market influence and level of criticality of the transaction (Askary, Goodwin & Lanis 2012).
How risk create material misstatement in financial statements
Since auditor has to examine and verify assets and liabilities of the Woolworth ltd that involve judgements and estimations of management. Therefore different estimation and adjustments can influence amount of transaction or item of financial statements (Leung, Coram & Cooper 2015). Following are some transactions or items that involve complex or high level of significant risk:
- Value or amount of provisions presented in financial statements
- In case of Woolworth ltd, valuation of put and call options (under future or derivatives)
- Valuation of inventory and other assets
- Impairment of assets and charging impairment loss or profit in financial statements
- In terms of capital assets management has to estimate useful life of assets that shall last long
- Discontinue operations
Above mentioned transactions and valuation are complex in nature and requires systematic accounting estimates, assumptions and judgements from management or accountant of Woolworth ltd. Therefore wrong estimation or judgement can put tangible effect on financial statement of Woolworth ltd during the reporting period. For example, if management estimates or make wrong assumption while estimating useful life of asset then whole process can lead to misstatement of financial statement (Report 2016).
Relevant assertion in this can be accuracy under which auditor has to examine and verify that amount of transaction after estimations and assumption is accurately presented in the financial statement during the reporting period. Another assertion that shall be undertaken to examine this inherent risk is of classification. Auditor with the help of substantive procedures has to verify that transactions which require estimations and assumptions has been classified and presented appropriately (Liya & Shufeng 2013).
Inherent Risk Factor 3- Inventory Obsolete and Level of competition
Describe the risk
Since Woolworth ltd is engaged in FMCG or food or beverage industry, therefore it becomes important for manager to calculate appropriate amount of inventory. Although in Woolworth ltd, inventory management system has been employed but it can be observed that in this industry, inventory obsolete level is slightly high. Other factors that influence inventory level and is an inherent risk for Woolworth ltd is level of competition present in the market. There are many other supermarkets that are operating their businesses and has captured major share of market palace (Miller, Cipriano & Ramsay 2012). Therefore any move of existing or new competitor of Woolworth ltd can influence its business operations. Therefore there is presence of inherent risk in the working environment of Woolworth ltd.
How risk create material misstatement in financial statements
For every business organisation and for Woolworth ltd also inventory covers majority of section in the financial statement. It has been analysed from the external and internal analysis of Woolworth ltd that they are largely dependent on their inventory (Wallace 2015). Woolworth ltd has high level of inventory obsolete level. Therefore wrong estimation of inventory and inclusion of obsolete items in the inventory can reflect wrong amount. Therefore auditor shall undergo physical verification of inventory during the audit. Another inherent risk that Woolworth ltd posses is of level of competition and its impact on inventory level. Since Woolworth ltd operates its business in uncertain business environment therefore auditor shall undertaken compliance procedure (Moraru, Grosu & Franca 2013).
In this case, classification assertion shall be used as obsolete inventory shall not be classified under inventory presented in financial statement. Another assertion shall be followed is of accuracy under which auditor shall examine and verify amount of inventory measured are reliable and accurate.
Inherent Risk Factor 4- External Business Risk Factors
On the basis of initial environmental analysis conducted on Woolworth ltd; it can be observed that they are exposed to many business risk factors. Business risk factors can be defined as the risk of operating company which means risk of business undertaken business operations. Material business risk involve market risk which itself is vast area of concern in terms of inherent risk. Strategic risk is another business risk that Woolworth ltd can face while operating their business (Moh’d & Karim 2015). Level of cost structure can be increased as management plans to expand business operations and this shall be lead to inherent risk (i.e. increase in cost structure). Another inherent business risk that Woolworth ltd can face is of operational risk that can undertake in the form of failure of business operations as compared to standards.
How risk create material misstatement in financial statements
Under inherent business risk category there are various risks that is involved in it that auditor shall undertake while preparing audit plan. Most important inherent business risk that auditor shall emphasis on is of operational business risk. Auditor has to make appropriate plan for management of operational efficient Woolworth ltd. Industrial disputes, accidents, work strikes and many other operational inefficiencies has to be identify and examine by auditor during audit. From the annual report of Woolworth ltd, it can be analysed that Woolworth ltd has been involved in many disinvestment, divestment and acquisition activities. Therefore there are huge inherent risk involve in these types of transactions that Woolworth ltd has to control. There are some regulatory or regulatory risk also exists that Woolworth ltd has to face. Auditor has to analyse how these risk will made impact on financial statements. For example, litigation and legal cases against Woolworth ltd and cases in which Woolworth ltd is favourable party. These transactions have to be examined in detail by auditor.
In this type of inherent risk, occurrence assertion will be impacted. Occurrence assertion means auditor has to verify that transactions recorded in the financial statements shall be related to Woolworth ltd only. Accuracy is the assertion that needs to be checked by auditor during audit of Woolworth ltd. Accuracy assertion means auditor has to examine and verify that transactions recorded in the financial statements related to business strategic (merger, acquisition or disinvestment) or operations involves accurate amount. Legal and litigation expenses involved in legal cases and suits have been reliably calculated or not have to be examined by auditor.
Audit risk model can be define as the model that incorporate all the risk together and make analysis of overall risk of misstatement on financial statements. There are three main components of audit risk model is inherent risk, control risk and detection risk that were identified and analysed by auditor during audit. Inherent risk identify above, will increases the evidence base for audit of Woolworth ltd as inherent risk is at higher side. When inherent risk is at higher side then audit has to undertake substantive procedure. Substantive procedure are those procedure or activities that auditor undertake to detect material misstatement in the financial statements (Burk & Hendry 2014). On the basis of above identified inherent risks in the Woolworth ltd, auditor has to do detail checking and has to undertake relevant assertions into account.
In case of Woolworth ltd most important concern matter is of making estimation, judgements and assumption while measuring different aspects of financial statement. Following audit risk model that shall be followed by auditor while assessing level of risk involve in estimation, judgements and assumption:
In this situation, auditor shall have higher level of reliance on controls and shall perforate moderate level of substantive test.
(Ruhnke & Schmidt 2014)
Potential amount of misstatement in the financial statement can be observe in the judgements and assumptions taken while calculating amount of impairment of assets, estimating useful life of asset and valuation of inventory. Management shall under take different aspect of assessing the impact of material misstatement of incorrect judgements and assumptions that they undertake. Valuations and judgements shall be based on expert opinion (Ruhnke & Schmidt 2014).
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