Inherent Risk Factors In Financial Reporting: Introduction And Account Balance Aspects

Inherent Risk Factors at Financial Reporting Level

What Is the Inherent Risk Finalcial Reporting Level?

Inherent risk is the risk associated with presence of material misstatements in financial statements of entity which are beyond the control of the management. The auditor uses the audit procedures to assess the degree of the risk in particular item of financial data presented in financial statements. Inherent risk factors are evaluated using professional judgment, nature of industry in which entity is operating, assets owned by an entity and nature of transactions entered into by an entity. The following are the factors that can enhance the degree of inherent risk in an entity under consideration:

Experience of Managerial Personnel is limited- Every company needs to have management which take fast and appropriate decisions according the environment of the company in which the company is operating. And if the management personnel have sufficient experience they react in very less time and enhance the growth of the company. In One Tel. Company the does not possess the required experience to react to the fast changing environment of the company in telecommunication industry. This inherent risk factor is beyond the control as the management cannot be easily changed (Cohen, Krishnamoorthy and Wright, 2007)

Inappropriate Composition of the Board- The composition of board of directors of an entity in such that the board should have all the necessary knowledge and experience. The board member can take part in making working decision in any organization. In the One Tel. management consists of nine members out of which 5 non-executive directors and 4 executive directors. More than 50% of the directors in the board are not taking park in making decision regarding the working of the company as they are non executive directors. The company composition can influence the decisions taken in board as per the non executive director who does not have knowledge about the affairs of the company at root level. This risk factor can have undue pressure in the decisions which are required to taken by the board and create the risk at the reporting level (Leong, 2009)

Economy condition of Industry – Economy plays major role in the performance of any company. The changes in the economy have a major impact on the working of the company. The economic growth can affect the growth level of the company as an external business risk factor. In One Tel. Company, the industries of telecommunications are developing at the faster pace. The company is facing high level of competition from the market which can be seen before the 1997. In 1197 there were 35 carriers in telecommunication industry for providing services as compared to 2 carriers. This will make pressure on the board of the company to react to these competitive strategies. The pressure increases the chances of risk of manipulation by the management of the company.

Inherent Risk Factors at Account Balance Level

Inappropriate monitoring of financial performance –The financial performance of the company plays the major role in the success story of an entity. The management should review the financial performance after regular intervals to assess the areas where risk can be happened and corrective actions are necessary. In the One Tel Company, the company is suffering from huge losses, the management of the company is not taking any decisions regarding the same and no corrective action has been taken by the board to reduce the level of financial losses. Even though the market share of the company is also decreasing but the management is not responding to these. This shows the inability of the board of the company and increased the level of inherent risk.

Lack of innovative technologies – The company should be develop their technologies and procedures time to time so the technologies involved are not obsolete as per the market conditions of the industry in which the company belongs. In One Tel Company, the company belongs to telecommunications industry in Australia. The industry is developing at very faster pace from landline phone to mobile phone and moving towards the internet age. The company is not able to develop the carriers and carriers are taken on lease which increases the cost of the company but the revenue is reducing day by day due to cater the competitive prices in market making the company old stock obsoletes. This can be major inherent limitations as the auditor has to take into consideration the loss incurred from decrease in value of inventory and increases the assessment in detail.

From the above factors identified by the auditor as inherent risk factors, some can considered to be present because of the business risks factors in an organization. Business risk can be related to operations, strategy, finance and reputation of the business. Strategic Business risk refers to risk factors present in business because of the management policies is not being followed by the company. The factors like inappropriate composition of board, inappropriate monitoring of financial  performance , economic conditions of industry are strategic business risk assessment factors which can also evaluated by management at time of assessing the business risks (Knechel, 2007).

The auditor should consider the following inherent risk factors are assesses at account balance level which increases the assessment and level of the substantial audit procedures:

Review of Inventories – As the industry is growing at very faster pace and the technological developments are taking place in the telecommunications industry, the company’s inventory as group has been increased from $ 2.1 million to $ 5 million in comparison to the decrease in revenue. This increases the chances of obsolete inventory and the huge losses on account of the same in the company. This inherent risk factor can affect the liquidity position of the company and the auditor has to test in details for verify the inventories and their balances (Miller, Cipriano and Ramsay, 2012)

Going Concern

Depreciation and Amortization – The technological developments are making company’s technologies which are part of noncurrent assets valueless. This increase the impairment and depreciation of the assets of the company 3times from the previous year. Depreciation and amortization was $ 35.3 million as compared to $ 12.3 million in 1999. This is because the company is acquiring the new technologies frequently and the cost of the new intangibles and equipments increases the financing risk on the company which in turn increases the level of inherent risk for the auditor.

Abnormal items- these can be the extra ordinary items or expenses or losses that the company has incurred because of some unusual transactions. In the financial statements of the company the Abnormal item which are charged as expenses reducing the profitability of the company were $ 33.5 million in 2000 as compared to $ 1.4 million in 1999. The increases level of these extra ordinary items requires the auditor attention to assess the inherent risks which are present at account balance level.

Issues of Shares- The industry in which company is operating requires huge funds either from the banking institutions or any other financial institutions or from the issue of shares or debentures of the company and more importantly from the own profits of the company that might be or will be retained in the business of the company for future growth and prospects. In the given situation the company has received an amount of 818.50 million dollar as proceeds from the issue of share capital of the company during the year as compared to 280.30 million dollar in the previous year. On the face of the balance sheet it is reflected that the company has issued share capital only because to run its business in the efficient and effective manner as the company has suffered the loss of 282.10 million dollar in the current financial year. Also the company has adopted the same technique in the last year but not because of the less profit but because of the less receipt from the customers and more payment to suppliers and employees (Shariff and Chan, 2008).

As per the generally accepted accounting principles, the financial statements of the company are required to be prepared on the basis of the assumption that the company will operate and function effectively in the future and will never stop its functions and also does not have the intention to close the business of the company. As per the Australian accounting standard, the concept of going concern plays very important part in the preparation of the books of accounts of the company and thereafter the financial statements of the company. In case the going concern is considered than the books of accounts will automatically show that the company has intention to work in future and that’s why the profit and loss and balance sheet has been prepared in actual. In case the circumstances exist that the going concern assumption is affected then the profit and loss account and balance sheet shall be prepared in the manner as if the company is going for liquidation in the next reporting period. Apart for the requirements of the accountants, the auditors of the company is also required to check whether the accounts are prepared on the basis of the going concern assumption and in case he finds that the financial statements so prepared has not been made on the going concern than the auditor shall have to report the fact as Key Audit Matters in accordance with the relevant accounting standard in the audit report. The assessment of the going concern assumption shall be made purely on true and fair basis. It should not be assessed purely on the basis of the financial statements of the company but also the other factors which may affect the functioning of the company in the future years. 

In the given situation, Company One Tel, being listed and operating in Australia, has been functioning through six of its segments geographically located in different parts of the World. As per the given case study, the area of the going concern shall be assessed as high and can in future affect the financial position and performance of the company (Ryu and Roh, 2007)

Accumulated losses: The company has in its consolidated financial statements have shown that the company has incurred the loss of 230.40 million dollars (earnings before interest, depreciation and tax and amortization) and leading to the accumulated loss at the end of the financial year of 2000 as 282.10 million dollar as compared to the profit of 9.1 million dollar in the last financial year of 1999. The same have eroded the shareholders funds by 23% in the one financial year only and if the same condition continues then there might be the possibility of getting the whole of the shareholders funds eroded in the next four years.

Negative Cash flow from operating activities: The Company has reported the negative cash flow from operating activities amounting to 168.90 million dollar in the year 2000 as compared to 28.90 million dollar in the year 1999. The decrease has been majorly due to the increase in the payments made to the supplier and employees of the company and correspondingly less payment received from the customers. This is the shocking situation for the company and if the same happens for some period then the company will sooner face the situation of the short term insolvency.

Major reliance in Australia Line: The Company has reflected that the out of the total revenue of 100, sixty four represents the amount of revenue that the company generated from its segment located in the country of Australia. Along with that it is mentioned that there are three competitors in the market who have the same line of business and have capture the market share of 57%, 31% and 11% respectively by Telstra, Optus and Vodafone. It means if these competitors in case builds or develops some innovative technology products which means a lot to the current era customers then the company will be going to survive from the loss of market share and more importantly the company will have to decide whether the same line of business shall be continued or not (Blay and Geiger, 2013).

Apart from these factors there are other factors too like inappropriate technologies and lack of experienced staff and team which can affect the going concern assumption of the company

References

Blay, A.D. and Geiger, M.A., 2013. Auditor fees and auditor independence: Evidence from going concern reporting decisions Contemporary Accounting Research, 30(2), pp.579-606.

Cohen, J.R., Krishnamoorthy, G. and Wright, A.M., 2007 “The impact of roles of the board on auditors' risk assessments and program planning decisions. Auditing: A Journal of Practice & Theory, 26(1), pp.91-112.

Knechel, W.R., 2007. The business risk audit: Origins, obstacles and opportunities Accounting, Organizations and Society, 32(4), pp.383-408.

Leong, C.T., 2009, “Inherent risk assessment—a new concept to evaluate risk in preliminary design stage- Process Safety and Environmental Protection, 87(6), pp.371-376

Miller, T.C., Cipriano, M. and Ramsay, R.J., 2012 Do auditors assess inherent risk as if there are no controls? Managerial Auditing Journal, 27(5), pp.448-461

Ryu, T.G. and Roh, C.Y., 2007, the auditor's going-concern opinion decision- International Journal of Business and Economics, 6(2), p.89

Shariff, A.M. and Chan, T.L., 2008, Inherent Risk Assessment- In the 2008 Spring National Meeting