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Inherent Risk Assessment


You are the auditor.  I am your client.  I work for Newport Soup, Inc (NSI).  NSI’s year-end is December 31, 2014.  You are doing this assignment NOW (2+ months before year-end) as part of Audit Planning.  Address your memo to your Audit Manager.


NSI makes soups and sells them in the United States and all around the world.  After years of losing popularity in the US, soup has made a comeback as evidenced by a 10% increase in soup consumption in 2014 relative to 2013 (US Dept of Agriculture).  While end consumers of NSI’s soup are individuals, the bulk of NSI sales are to grocery, department and convenience stores.  Three of NSI’s most significant grocery store customers are Harris Teeter, Publix and Alexis Foods.


NSI has never had to restate their financial statements and has a reputation for having a fairly ethical management team.  Top management (i.e., CEO, CFO) receives all cash (no shares of stock) salaries that are not impacted by NSI’s financial performance.  NSI has met or beaten analysts’ EPS forecasts in 12 of the last 12 quarters.


Your task is to assess the inherent risk for the following un-audited balances that NSI will be including in its financial statements for the year ended December 31, 2014


  • Sales Revenue
  • Cost of Goods Sold


  • Accounts Receivable
  • Allowance for Doubtful Accounts
  • Inventory
  • Reserve for Inventory Spoilage


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    Recent NSI Un-audited data (from the September 30, 2014 Report (9 months of activity):




    Sales Revenue (all sales are credit sales) $1,350,000
    Cost of Goods Sold $783,000
    Accounts Receivable

    Less:  Allowance for Doubtful Accounts

    Net A/R






    Less:  Reserve for Spoilage

    Net Inventory






    Recent Newport Soup financial data (audited):


    2013 Balance (audited)

    Sales Revenue $2,400,000
    Cost of Goods Sold $1,500,000
    Accounts Receivable

    Less:  Allowance for Doubtful Accounts







    Less:  Reserve for Spoilage






    Please prepare a persuasive memo that includes an IR assessment of EACH of the 6 balances.Use Excel, and other material for memo writing and inherent risk assessment. Print out your memo (with exhibits) with your inherent risk assessments.


    Between now and Oct 8, you are NOT required to research the soup industry.   I am taking the research component of assessing inherent risk away from you SO THAT you will focus on thinking and getting your thoughts down on paper.  You SHOULD email me as many questions as it takes for you get what you need.  As your client, I have several documents that will help you, BUT you need to ask me for them in a manner that is clear.Remember that an inherent risk assessment is about number crunching, thinking AND asking good questions.


    At a minimum, you will want to analyze changes from year-to-year and evaluate whether the changes in certain balances and ratios “make sense.”


    A few of the ratios that you might find helpful in completing this assignment include

    • COGS as a percentage of Sales Revenue
    • Days to collect receivables = 365 / (2014 Sales / Gross A/R balance 9/30/14*)
    • Allowance for Doubtful Accounts as a percentage of period-end Gross A/R
    • Days to turn inventory = 365 / (2014 COGS / Gross Inventory balance 9/30/2014*)
    • Reserve for Spoilage as a percentage of period-end Gross Inventory


    The memo/outline that I distributed on IR assessment is meant to serve as a guide for assessing the IR for each balance in this assignment


    *I know that the “proper” ratio is to use the average of the balances from the current and previous year, BUT since you only have data as of 9/30, this is a rougher (and easier) calculation for you to handle.  Also, it is important to note that balance sheet balances are typically expected to stay “about the same” between 9/30 and 12/31 unless some major economic event is going to transpire.  The same cannot be said of Income Statement balances…as 9/30 income statement balances only reflect 9 months of activity, while 12/31 income statement balances reflect 3 more months of activity (a total of 12 months worth).  That is a STRONG hint.


    Management’s Assertions (MA)


    When we say that the financial statements are the responsibility of the client, we say that the client’s management asserts the following things (known as Management’s Assertions) about every transaction, reported period-end balance, and disclosure.


    Remember, an auditor’s job is to gather ENOUGH EVIDENCE to provide REASONABLE assurance that the client’s processes, balances and disclosures are consistent with their assertions, subject to a MATERIALITY threshold set by the auditor.


    Today, we will discuss what management asserts about

    • Transactions during a year
    • Account Balances at year-end
    • Disclosures made at year-end


    Today, auditors are trained to consider Management’s Assertions using 3 sub-groups

    • Transactions during a year
      • Occurrence – Nothing fictitious gets booked
      • Completeness – They don’t leave any transactions out of their books

      • Authorization – Nothing happens in the company’s business or its books without proper approval
      • Accuracy – No numerical mistakes get made without being caught/corrected

      • Cutoff – Everything is booked in correct time period (i.e., revenue booked when 2 conditions are met…not before and not after)
      • Classification – Amounts get booked to the proper accounts (i.e., expenses get treated as expenses and not assets)

    • Account Balances at year-end
      • Existence – Nothing fictitious has been included in year-end balances
      • Rights and Obligations – They own what they say they own (which is MORE than existence) and they owe what they say they owe (it isn’t anybody else’s debt)

      • Completeness – They didn’t leave any amounts of their year-end balances
      • Valuation – All items in financial statements are reported at their appropriate value
    • Disclosures made at year-end
      • Occurrence and rights and obligations – Nothing gets made up
      • Completeness – Nothing gets left out

      • Classification and understandability – Things are presented in a manner that is appropriate (i.e., ST vs LT) and clear (i.e., aggregation should make sense and not just make truth easier to hide)
      • Accuracy and valuation – Things a) are presented in a manner that is clerically accurate and b) are appropriately valued


    Types of Evidence Auditors Gather to Support (or Refute) MA


    Whether auditors are gathering and analyzing evidence to A) assess inherent risk (IR) or control risk (CR) as steps in determining the amount of balance testing that needs to be done or B) the balance testing itself, we MUST collect evidence that either supports or refute the assertions that are client is making in its financial statements.  Today, we will discuss the types of evidence auditors collect and how to assess its usefulness.


    Evaluating evidence collected IN ORDER TO VERIFY WHETHER OR NOT MANAGEMENT’S ASSERTIONS HOLDon 3 dimension

    • Relevance (depends on assertion)
    • Reliability (how good is it?)
      • Independence of provider
      • Auditor’s direct involvement in generating evidence

      • Level of objectivity (degree of judgment involved – NONE is best)
      • Qualifications of provider
      • For client-generated documents, the persuasiveness of the evidence is positively related to your assessed effectiveness of the client’s IC

    • Cost effectiveness (cost) – is the effort/money spent gathering the evidence “worth it”?



    Types of evidence

    • Physical Examination or Inspection of Tangible Assets (seeing it)

      • Good for what types of accounts and assertions?
      • How reliable?
      • Potential cost issues?
    • Confirmation (3rd party reply to auditor request)
    • Good for what types of accounts and assertions?

    • How reliable?
    • Does this sound costly or not?
    • Re-performance (auditor does something client has already done)
    • Recalculation (“re-compute” and “foot” and “ticking-and-tying”)


    • How reliable? How costly?


    • Inspection of Documents (Internal and External)
    • How can this complement Physical Examination evidence?
    • Vouch versus Trace

    • How reliable (depends on Internal/External and CR Assessment, if an internal document)?
    • Analytical Procedures (compare pre-audit numbers to benchmarks)
      • Required during planning and completing audit (“attention directing”)
      • NOT a substitute for other evidence!!!…rather, a SUPPLEMENT

      • How reliable? (it depends on benchmarks)
      • Not costly at all
    • Scanning (journals for weird or late transactions, warehouses for ____)
    • Inquiry

      • How reliable?
      • Not costly at all

    • Observation (Surprise vs planned)



    Types of audit evidence typically collected for IR Assessment

    • Inspection of external documents (i.e., articles about client, industry, economy, etc.)
    • Inspection of internal documents (i.e., budgets, marketing reports, etc.)
    • Analytical Procedures
    • Inquiry


    Types of audit evidence typically collected for CR Assessment

    • Re-performance
    • Re-calculation
    • Inspection of internal and external documents
    • Observation


    All types of audit evidence tend to get collected for balance testing.


    Relating the Risk of Incorrect Acceptance for a Substantive Test of Details to Other Sources of Audit Assurance In Table 1 it is assumed, for illustrative purposes, that the auditor has cho- sen an audit risk (AR) of 5 percent for an assertion. Table 1 incorporates the premise that internal control cannot be expected to be completely effective in detecting aggregate mis statements equal to tolerablem is statement that might occur.

    The table also illustrates the fact that the risk level for substantive procedures for particular assertions is not an isolated decision.Rather,it is a direct consequence of the auditor’s assessments of the risk of material misstatement (RMM) (combined assessments of inherent and control risks), and judgments about the effectiveness of substantive analytical procedures(AP)and other relevant tests of details (TD), and it cannot be properly considered out of this context.[1] Table 1 Allowable Risk of Incorrect Acceptance (TD) for Various Assessments of RMM and AP; for AR = .05

    Auditor’s subjective assessment of risk of material misstatement. Auditor’s subjective assessment of risk that’s ubstantive analytical procedures and other relevant substantive procedures might fail to detect aggregate misstatements equal to tolerable misstatement. RMM AP 10% 30% 50% 100% TD 10% * * * 50% 30% * 55% 33% 16% 50% * 33% 20% 10% 100% 50% 16% 10% 5% * The allowable level of AR of 5 percent exceeds the product of RMM and AP, and thus, the planned test of details may not be necessary unless specified by regulation or other Standards (e.g., confirmation or inventory observation procedures).


    Note: The table entries for TD are computed from the illustrated model: TD equals AR/(RMM x AP). For example, for RMM = .50, AP = .30, TD = .05/(.50 x .30) or .33 (equals 33%).
    [1] As amended, effective for audits of financial statements for periods ended after September 30, 1983, by Statement on Auditing Standards No. 45. Footnote deleted by the issuance of Statement on Auditing Standards No. 111, March 2006.]

    AU §350.48


    Audit Sampling 2079 Table 2 Factors Influencing Sample Sizes for a Test of Details in Sample Planning Conditions leading to Factor Smaller sample size Larger sample size Related factor for substantive sample planning


    a.Assessment of inherent risk. Low assessed level of inherent risk. High assessed level of inherent risk. Allowable risk of incorrect acceptance.


    b.Assessment of control risk. Low assessed level of control risk. High assessed level of control risk. Allowable risk of incorrect acceptance.


    c.Assessment of risk for other substantive procedures related to the same assertion (including substantive analytical procedures and other relevant substantive procedures). Low assessment of risk associated with other relevant substantive procedures. High assessment of risk associated with other relevant substantive procedures. Allowable risk of incorrect acceptance.


    d.Measure of tolerable misstatement for a specific account. Larger measure of tolerable misstatement. Smaller measure of tolerable misstatement. Tolerable misstatement.
    e.Expected size and frequency of misstatements. Smaller misstatements or lower frequency. Larger misstatements or higher frequency. Assessment of population characteristics.
    f.Number of items in the population. Virtually no effect on sample size unless population is very small.

    g.Choice between statistical and nonstatistical sampling Ordinarily, sample sizes are comparable. Auditing Standards No. 111.] AU §350.48

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