Auditing and Inherent Risk Management

Question: Discuss about the Auditing and Inherent Risk Management. Answer: Factors leading high inherent risk at financial report level: Inherent risk refers to the risks in respect of omission or error in the financial statements because of factors other than weak control system. In this context, Lothe (2013) stated that the chances of inherent risk tends to be high in case of financial audit in case the nature of transactions are complex or if high level of estimates are required for reporting purpose. Companies operating in an environment having high level of regulation without any committee to oversee audit procedures in its organization. On the other hand, the level of inherent risk is also dependent on the financial exposure of an organization. Complex transactions, forecasting for provision requirements and others can lead to inherent risk. In current scenario, the following would have contributed to the high level of inherent risk for One Tel at the financial reporting level: Market competition: Market competition is mainly determined by the number of rival companies operating in the market. The competition in the Australian telecom industry has increased ever since the same was deregulated as currently 35 telecom operators are there in the Australian telecom industry. In this context, McNeil et al. (2015) stated that a high level of market competition raises inherent risk of a company pertaining to financial audit because it becomes tougher to estimate future sales and customer behavior. Availability of substitute services: Presence of a high level of substitute products could raise the chances of bad debt in the telecom industry for a company (Mironeasa and Codină, 2013). It is mainly because of the fact that availability of a large number of substitutes in the market often encourages customers to switch over to other telecom service providers even without clearing the dues to existing telecom operator. This increases the chances of bad debt for One Tel. Actual bad debts could be higher than the estimated one. Incorrect reporting of bad debts in the financial statement could also lower the profit level and impact the deferred tax amount as well. Revenue recognition issue: The nature of telecom services makes it difficult for One Tel in respect of revenue recognition. In other words, the problem is as to when a revenue needs to be recognized. As mentioned by Rust et al. (2011), presence of postpaid connection makes it difficult for a company to recognize its revenue. Here, a postpaid customer of One Tel enjoys telecom services for an entire bill cycle however the bill generated after the completion of a bill cycle is accepted by the customers after a week or week. So, the question arise as to when One Tel should recognize its revenue, at the time of providing services or once the customer accepts the bill. The problem becomes more severe during the close of an accounting period because on the date of the trial balance and income statement it has to be determined how much proportion of the services offered to customers be recognized and reported as revenue. Board autonomy: Autonomy refers to the independence of the directors of the board of a company, One Tel in present case. The autonomy of the board members is determined to a great extent by the number of non-executive directors in the board (Sadgrove, 2016). Higher the number of non-executive directors greater is the autonomy of a board and vice versa. In current scenario, the proportion of non-executive directors of One Tel is just above 50%. An almost equal proportion of non-executive and executive directors in the board of One Tel raises the level of inherent risk for the company. Background of the board members: The inherent risk level tends to be higher when maximum of the board members are from non-financial background or do not have much exposure to financial reporting standards (Sanderson, 2013). It is always a tendency of telecom companies to hire directors from technical background and experience in the telecom industry. However, this practice increases the inherent risk factor in relation to audit of the concerned organization. Lack of audit committee to oversee auditing function: Absence of a form audit committee further increases the inherent risk for One Tel. Audit committee is mainly responsible for monitoring and reviewing audit functions in an organization. It is also the responsibility of the audit committee to communicate and coordinate with external auditors in respect of auditing. Therefore, presence of an audit committee makes the auditing process easier for the external auditors. Similarly, absence of an audit committee might lead to intentional or unintentional omission of vital transactions in the financial statements. This again raises the inherent risk level of One Tel. Training facilities: In the view of Waldron (2016), presence of training facilities in organizations often reduces the degree of inherent risks for the organization. Put it differently, availability of training program makes accountant and internal auditors more competent towards making appropriate financial reporting. Such trainings are useful in clearing doubts and confusion of the staffs in matters of audit. On the contrary, absence of adequate training facilities could raise the inherent risk level for One Tel. State of the economy: The current state of economy is characterized by high level of growth which increases the inherent risk for One Tel. A highly growing economy offers various chances for business expansion and revenue generation for a company which leads to multiple investment and lending transactions (Bowling, 2014). This makes the nature of transactions more complicated than ever before. This further raises the level of inherent risk. Strategic level factors: Above all the factors so discussed, board autonomy, background of the board members, absence of training facilities, lack of audit committee could be viewed as part of strategic discussion and decision making for One Tel. The company can discuss these issues at the strategic level. The purpose of such discussions would be to lower the risks associated with these factors which further contributes to a higher level of inherent risk for the audit. It is the responsibility of the top management of One Tel to arrange for proper training facilities of the internal auditors and nominate board members from core financial background to lower the inherent risks of the company in respect of audit. Furthermore, decision as to formation and functioning of audit committee also falls under the purview of the top management (Beck and Mauldin, 2014). Factors contributing to inherent risk at account balance level: There are certain factors that influence the inherent risk at the account balance level of One Tel. Identification and consideration of these factors can help in reducing the inherent risk at the account balance level. These factors are discussed in detail below: Differential pricing system: The problem with One Tel is that it operates in the telecom sector in which there are no fixed selling price for the services being offered to the customers. There are a huge difference in the price charged by One Tel and other telecom operators from the customers. The difference in service rates is mainly due to the difference in usage of telecom services among the customers and the type of connection used by the customers. It is further observed that One Tel offers various types of telecom connections and various types of tariff packs, recharges and top ups to the customers. This creates problem in accounting for sales revenue. Sales is entered on the credit side of Trial balance and is also recognized in the profit or loss statement. However, undervaluation of sales account would lower the credit side of trial balance and overstatement of sales account can lead to increase of the debit side of trial balance in an incorrect manner (Zeff, 2016). As a result, the debit and credit sid e of the trial balance would not agree. Furthermore, in case both cash and sales are reduced or increased by same amounts even wrongly, then the trial balance would agree as cash is entered on the debit side and sales is entered on the credit side. However, the trial balance agrees in an incorrect way. This is known as compensating error in accounting terminology. Thus, the pricing system increases inherent risk at the account balance level. Prevalence of two modes of service offering: There are two major modes through which telecom services are offered to the customers. These are prepaid services and postpaid services (Zadek et al. 2013). This strategy is followed by One Tel and also by other telecom companies in Australia. Prepaid customers make payment prior to using services in the form of recharge and top ups. On the contrary, postpaid customers pay for telecom services after using the service. In other words, postpaid customers of One Tel are on a billing system and a bill is generated after the close of each billing period. Therefore, the prepaid customers pay in advance whereas postpaid customers pay post use of telecom services. This makes account balancing difficult for the accountants because it becomes hard to determine the amount of prepaid incomes, provision for bad debts and accounts receivables. The confusion becomes as to should the amount received from prepaid customers be treated as direct sales or like prepaid incomes until the services are used . Also, problem arises regarding the amount of provision for debtors and account receivables. It is often a tendency among a good number of postpaid customers to complaint of billing discrepancies after getting the bill and in many case such customers even switch over to other service provider without even paying the current dues. Therefore, accountants might make mistakes in relation to account receivables and provision for debtors. Here, the main issue is whether the billing usage of the postpaid customers needs to be considered as accounts receivable or provision for doubtful debts. In case, the amount is to be segregated into both the accounts then the question arises as to in what proportion the amount is to be segregated into accounts receivable and provision for doubtful debts. Accounts receivable is entered on the debit side of trial balance whereas provision for debtors is entered on the credit side of the trial balance and this increases chances of errors at the account ba lance level. Evaluation of going concern aspect of One Tel: Going concern concept refers to a popular accounting concept which assumes that an organization will stay in the business for a long period of time (William et al. 2016). In other words, it also means that the entity would not stop the business or liquidate its assets or resources all of a sudden. This assumption has a major impact on the accounting treatment of business transactions. For example, based on this going concern concept, intangible assets like patents and others are allocated over the entire useful life of the same. Similarly, the concept of prepaid income expenses and accrued income expenses have also been generated from this going concern concept. In current scenario, the going concern level of One Tel can be considered as moderate. This can be justified by both financial and non-financial factors. Financial factors include fast economic growth of the country. At present, the telecom sector of Australia is growing rapidly which reduces the chances for One Tel to go into liquidation. Also, the company has been able to get a strong market share in the telecom industry which is yet another major factor contributing towards stability of the company in coming future. On the other hand, there has been substantial increase in the cash level of One Tel from $172.6M in 1999 to $335.7M in 2000. The total current assets has risen from $296.2M in 1999 to $628.10M in 2000. Increased debt financing remains a concern. In addition, One Tel has also suffered a huge amount of financial loss in 2000 compared to 1999. On the other hand, cash flow from both operating and investing activities for the year have been $-168.9M and -614.9 respectively. Furthermore, the Australian telecom sector is expected to see the entry of more number of telecom operators in the coming years. Reference List: Beck, M.J. and Mauldin, E.G., 2014. Who's really in charge? Audit committee versus CFO power and audit fees.The Accounting Review,89(6), pp.2057-2085. 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