Understanding of entity and inherent risk assessment (including case studies)

Auditing – Study Notes Chapter 10 Understanding of Entity and Inherent Risk Assessment
CHAPTER TEN
UNDERSTANDING OF ENTITY AND
INHERENT RISK ASSESSMENT
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PART A – RISK BASED APPROACH TO AUDITING
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PART B – INHERENT RISK ASSESSMENT, CLASSIFICATION AND RESPONSE
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PART C – RISK ASSESSMENT IN SPECIALIZED ENTITIES
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Coverage from Question Bank:
After completion of this chapter, you will be able to attempt following questions in ICAP's Question
Bank:
Question # in ICAP’s Question
Bank
Type of Question Question # in ICAP’s Question Bank
Type of
Question
Q. # 18a,b (Assertions) Concept Review Question Q. # 31b (Hurricane) Case Study
Q. # 25 (Discussions and judgment) Concept Review Question Q. # 32b (Zakir Co) Case Study
Q. # 26 (Dynamic) Case Study Q. # 33 (Hajira) Case Study
Q. # 29 (Calm Co) Concept Review Question Q. # 67a (Analytical procedures and materiality) Case Study
1 By: Muhammad Asif, ACA

PART A – RISK BASED APPROACH TO AUDITING
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Transaction-based/ Vouching-based/ Direct verification / Substantive Approach:
Under this approach no reliance is placed on entity’s system of internal control to determine level
of detailed testing of transactions. This approach is used by auditor when entity’s internal controls
are absent/weak, or number of transactions is low. Auditor may set testing level between 50% to
100% of the population.
This approach is often used when auditing financial statements of a small entity.
The system-based approach
System based approach means auditor places reliance on entity’s system of internal control to
determine level of detailed testing of transactions. This approach is used by auditor when entity’s
internal controls are strong and auditor decides to rely on internal control.
Following are stages of system-based approach:
1. Make preliminary assessment of strength of internal control.
2. Perform test of control to confirm whether preliminary assessment is correct.
3. Determine level of detailed testing of transactions based on results of tests of controls (i.e. if
internal controls are strong, reduce level of testing and vice-versa).
Risk-Based Approach:
Under risk-based auditing, objective of auditor is to reduce audit risk to an acceptable level. This is
achieved by performing detailed testing on areas where there is high risk of material misstatement.
Following are stages of risk-based approach:
1. Auditor sets appropriate level of audit risk in accordance with nature of engagement and
firm’s quality control policies and procedures.
2. Auditor performs risk assessment procedures to obtain understanding of entity and
internal control to assess risk of material misstatement.
3. Auditor uses “audit risk model” to calculate acceptable level of detection risk i.e.
DR = AR/(IR * CR)
4. Based on level of acceptable level of detection risk, auditor determines nature, timing and
extent of audit procedures.
CONCEPT REVIEW QUESTION
“The auditing techniques for audit testing now takes cognizance of risk element in the modern audit”. In the light
of this statement, explain risk based audit approach and vouching based audit approach. (04 marks)
(ICMA Pakistan, Winter 2009)
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Below is a presentation of audit risk model which elaborates how risk is assessed and used by
auditor in determining further audit procedures. This model is used by auditors in audit of all areas
of financial statements.

Risk Assessment Procedures
Understanding
of entity
Understanding of Internal
Control
Inherent Risk Strength
Weakness i.e.
Control Risk
RMM
(IR * CR)
Detection Risk
(AR/RMM)
Audit Risk
(set by firm)
Audit Procedures
Area
A
60% 80% 20% 12% 40% 4.8%
 Extensive TOC (because auditor
relies more on internal control)
 Reduced Substantive
Procedures (because detection
risk is high)
Area
B
60% 20% 80% 48% 10% 4.8%
 Reduced TOC (because auditor
relies less on internal control)
 Extensive Substantive
Procedures (because detection
risk is low)
Inherent Risk:
The susceptibility of an assertion about a class of transaction, account balance or disclosure to a
misstatement that could be material (either individually or when aggregated with other
misstatements), before consideration of any related controls.
Control Risk:
The risk that a misstatement that could occur in an assertion about a class of transaction, account
balance or disclosure and that could be material (either individually or when aggregated with other
misstatements) will not be prevented, or detected and corrected, on a timely basis by the entity’s
internal control.
Risk of Material Misstatement:
The risk that the financial statements contain material misstatements (individually or in aggregate)
prior to audit. This consists of two components at assertion level i.e. Inherent Risk (IR) and Control
Risk (CR).
Detection Risk:
The risk that the procedures performed by the auditor to reduce audit risk to an acceptably low
level will not detect a misstatement that exists and that could be material (either individually or
when aggregated with other misstatements).
Audit Risk:
The risk that the auditor expresses an inappropriate opinion when financial statements are
materially misstated. Audit risk is a function of Risk of Material Misstatement and Detection Risk.
Study Tips
1. Audit Risk = Inherent Risk * Control Risk * Detection Risk.
2. Inherent risk cannot be controlled.
3. Control risk can be controlled/reduced by client through internal control.
4. Detection risk can be controlled/reduced by auditor through audit procedures.

Suppose, you are an Audit Manager in a medium sized audit firm and M/s. Alpha Designers Limited is one of your key
audit clients. You are in the process of audit planning of the client for the year ended December 31, 2014 and the initial
meeting for briefing the engagement team has been scheduled next week. You have been requested by the team in-charge
to brief the team on key aspects of the audit risk to be applied while carrying out the audit under the International
Standards on Auditing.
Required:
(a)Discuss audit risk and its components in the meeting with the team. (08 marks)
(b)Enumerate the possible overall responses to address the assessed risks of material misstatement at the financial
statement level. (08 marks)
(ICMA Pakistan - March 2015)
What is the relationship between detection risk and combined level of inherent and control risk? (05 marks)
(CA Inter, Spring 2002)
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Definition:
Risk Assessment Procedures are auditor’s procedures to obtain understanding of entity and its
internal control to assess the risk of material misstatement at financial statement level and at
assertion level.
Examples of Risk Assessment Procedures (and sources of information):
Inquiry of management and others within the entity:
Auditor may inquire from management and others within the entity which may have information
relating to risk assessment. These others to inquire may include Internal audit function, TCWG, In-
house legal counsel, marketing or sales personnel and Employees involved in initiating, processing
and recording transactions.
Observation and Inspection:
Observation and inspection supports inquiries of management and others; and also provides
information about entity and its internal control e.g. observation and inspection of:
 Entity’s operations
 The entity’s premises and plant facilities
 Business plans, strategies, accounting records, and internal control manuals.
 Reports prepared by management and TCWG (e.g. interim financial statements, or minutes
of board of directors’ meetings).
Analytical Procedures:
Analytical procedures may identify unusual or unexpected ratios and relationships in financial
statements and may help in assessing the risk of material misstatement e.g. calculation and
comparison of debtors’ turnover ratio.
Discussion among engagement team
The engagement partner and other key engagement team members shall discuss the susceptibility
of the entity’s financial statements to material misstatement.
Objectives/Benefits of discussion among engagement team:
1. More experienced members share their insights based on their knowledge of the entity.
2. Team members exchange information about the business risks of entity and how
financial statements may be misstated.
3. Team members gain a better understanding of audit risk in specific areas assigned to
them, and how the results of their work can affect other aspects of audit.
4. Team members communicate and share new information obtained throughout the audit
that may affect the audit risk or audit procedures

The auditor performs risk assessment procedures to obtain an understanding of the entity and its environment, including
its internal controls. Briefly discuss all such procedures. (09 marks)
(CA Inter, Autumn 2007)
List the benefits associated with holding timely discussion among the team members in respect of matters susceptible to
material misstatements. (05 marks)
Your audit firm has just won a new audit client, Milky Way Technologies Co (Milky Way), and you have been asked by the
audit engagement partner to gain an understanding about the new client as part of the planning process.
Required:
Identify FIVE sources of information relevant to gaining an understanding of Milky Way Technologies Co and describe
how this information will be used by the auditor. (05 marks)
(ACCA F8 – December 2015)
PART B – INHERENT RISK ASSESSMENT, CLASSIFICATION AND RESPONSE
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Auditor is required to obtain understanding of entity and its environment. This understanding shall
cover following:
1. Relevant industry, regulatory and other external factors, including relevant accounting
requirements.
2. The nature of the entity and its operations, ownership and management structures.
3. The entity’s selection and application of accounting policies, including whether they are
consistence with applicable financial reporting framework, consistent with industry, and any
change in accounting policies is appropriate.
4. The entity’s objectives and strategies and those related business risks that may result in risks
of material misstatement in financial statements.
5. The measurement and review of the entity’s financial performance (through analytical
procedures).
List FOUR examples of matters the auditor may consider when obtaining an understanding of the entity. (02 marks)
Define and explain the term ‘business risk’. (05 marks)
(ICMA Pakistan, Winter 2008)
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Business Risk:
Business risk is a risk resulting from significant conditions, events, circumstances, actions
or inactions that could adversely affect an entity’s ability to achieve its objectives. Business
risks can also occur as a result of setting of inappropriate objectives, strategies or goals.
Understanding of business risks helps auditor in his risk assessment because most of the
business risks ultimately affect financial statements hence they also become risks of
material misstatement.

There are two levels of risk i.e. at Financial Statement Level and at Assertion Level.
Risk at Financial Statement Level:
Risks at the financial statement level refer to risks that affect financial statements pervasively and
potentially affect many assertions.
Examples of Inherent risks at financial statement level:
1. Risk of management override of control.
2. Integrity of management.
3. Management experience, knowledge and changes during the period.
4. Nature of the entity’s business and operations (e.g. high-tech or fashion based products,
highly regulated business, expansion through new products or new locations, intended sale
of business, significant transactions with related parties, new or complex IT system).
5. Declining economic conditions causing going concern problems (e.g. Poor liquidity/credit
position, Decreasing sales and profits, loss of key customers, increased competition).
6. Risk of fraud (e.g. due to unusual pressure on management to meet targets).
Risk at Assertion Level:
Risk at assertion level refers to risks that do not affect financial statements pervasively and affect
only specific identifiable assertions.
Examples of Inherent risks at assertion level:
1. Complex transactions
2. Non-routine transactions (e.g. purchase or disposal of fixed assets)
3. Judgmental transactions (e.g. pending litigations)
4. Accounts with history of errors
5. Large transactions/adjustments at period end.
6. Assets with high risk of misappropriation (e.g. cash or other movable/marketable assets)
The auditor is required to identify and assess the risk of material misstatement at both the financial statement and
assertion levels.
State what is meant by risk at financial statement level and assertion level. Give one example of risk at each level.
(03 marks)
What is an inherent risk? Give some examples of inherent risk at the financial statements level. (05 marks)
“The auditor shall perform risk assessment procedures to provide a basis for the identification and assessment of risks of
material misstatement at the financial statement and assertion levels.”
(i) Briefly explain what do you understand by the risk of material misstatement at financial statement level. (04 marks)
(ii) List down the risk assessment procedures as referred above. (02 marks)

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Response to Risk at Financial Statement Level:
To address risk at financial statement level, auditor shall design and implement overall responses
e.g.:
 Adequate planning
 Adequate application of professional skepticism
 Assigning more experienced and specialized staff e.g. use of experts if necessary.
 Adequate supervision and review of the audit work performed
 Incorporating unpredictability in nature, timing and extent of audit procedures
o Performing procedures on account balances not usually tested.
o Using different sampling methods.
o Performing audit procedures at different locations on unannounced basis.
 Making changes to audit procedures.
 More audit procedures at period end rather than at interim date.
 Obtaining more reliable audit evidence.
Response to Risk at Assertion Level:
To address risk at assertion level, auditor shall perform following further audit procedures:
 Tests of Controls (to be discussed in chapter # 11) and
 Substantive Procedures (to be discussed in chapter # 12).
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If during the course of audit, additional evidence is obtained by auditor from performing further
audit procedures which is inconsistent with information/evidence on which original risk
assessment was based, auditor shall revise risk assessment. For example:
 In performing tests of controls, the auditor detects deviations greater than original
assessment.
 In performing substantive procedures, the auditor detects misstatements greater than
original assessment.
“The auditor’s assessment of materiality and audit risk may be different at the time of initially planning the engagement
from at the time of evaluating the results of audit procedures.”
Briefly describe the reasons which may lead to such a change in the auditor’s assessment. (03 marks)
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Auditor is required to document following regarding risk assessment:
1. The discussion among the engagement team about the susceptibility of the entity’s financial
statements to material misstatement and decisions reached.
2. Risk assessment procedures performed, and understanding obtained regarding each aspect
of entity, and the sources of information from which the understanding was obtained
3. Risk of material misstatement assessed at financial statements level and at assertion level.
4. Significant risks identified and controls related to significant risks.

An auditor is required to identify and assess the risks of material misstatements to provide a basis for designing and
performing further audit procedures.
Required:
State the matters which you would include while documenting the risk identification and risk assessment procedures.
(06 marks)
PART C – RISK ASSESSMENT IN SPECIALIZED ENTITIES
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What is a Small Entity:
Small entity means a sole-proprietorship or a partnership.
Features, Risks and Effect on Audit of Small Entity:
Features/Characteristics of
Small Entity
Risks and Effect on Audit
Common ownership and
management
This can increase audit risk (as owner-manager is easily able to
override any internal controls) or decrease audit risk (as owner is
actively involved in day to day operations). Risk assessment will
depend on auditor’s knowledge of the integrity and competencies.
Few Employees
There will be lack of internal control e.g. no segregation of duties
or no authorization controls. Control risk will be increased.
Auditor shall place less reliance on controls and large amount of
substantive procedures will be performed.
Less sophisticated accounting
system
Use of standardized or less sophisticated accounting system may
fail to provide adequate audit trail as they are not specific to needs
of entity. Further, system errors may occur due to inadequate
programming or training of staff on use of package.
Auditor is unlikely to use CAATs.
No full time well-qualified
accountant
Auditor is likely to himself prepare financial statements which may
create self-review threat. Therefore, safeguards should be applied
to reduce threats (e.g. use of different teams).
Describe the specific risks involved in the audit of a small business. (05 marks)
How is the audit of a small business different from that of a large organization? (05 marks)

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What is a Charity or NFPO:
A not for profit organization raises funds from general public and spends its funds on defined
beneficiaries in accordance with its objects.
Inherent Risks in NFPO and their effect on Audit Approach:
Risks associated with Income:
Risk and explanation of risk Effect on Audit Approach
Risk Factor: If income of charity is derived wholly
from donations.
Donation income is likely to be unpredictable and will fall
in poor economic conditions.
Audit report may need to be modified because of going
concern assumption affected by uncertainty of future income.
Risk Factor: If cash is collected by volunteers from
various places.
There is a risk that donation may be stolen by volunteers
due to lack of controls (as no sales invoices are raised).
Audit report may need to be modified because lack of
evidence to ensure completeness of income.
Risks associated with Expenses:
Risk and explanation of risk Effect on Audit Approach
Risk Factor: If constitution of charity specifies how
the income is to be spent/expended:
There is a risk that expenditures can be incurred for
objects outside of constitution of Charity.
Expenditures will have to be carefully reviewed to ensure
that expenditures are not ‘ultra vires’ the objectives of
Charity.
Risk Factor: If there are specific instructions about
utilization of donation.
There is a risk that donation may be recorded
inappropriately (e.g. misclassification between recording
as liability or income) or may be spent inappropriately
(e.g. it may not be spent in accordance with instructions
of the donor).
Auditor will carefully check whether:
 Specific donations is recorded as liability.
 Specific donation is expended in accordance with
instructions of donor.
Risk Factor: If constitution of charity requires that
administration expenditure cannot exceed a certain
percentage of income.
There is a risk that administration expenditure can
exceed this limit and may be misclassified by
management.
Auditor will check whether this limit has exceeded. Auditor
will also check other areas if there are unusual increase in
expense for possibility of misclassification.
Risk Factor: If there are complex regulations and tax
rules applicable on charity.
There is a risk that rules will be broken due to lack of
knowledge and expertise.
Auditor will ensure that staff is familiar and complying with
relevant regulations and tax rules.
Al-Madad Foundation (AMF) is a charitable organization. It receives donations which are utilized to help the destitute
persons in accordance with the rules and regulations prescribed by the AMF’s Trust Deed.
The donations are received from the following sources:
(i) Cash collected from the general public through charity boxes placed at key points in hospitals, airports, superstores
etc.,
(ii) cash and cheques received from individuals and institutions at AMF’s office; and
(iii) cash from generous individuals who prefer to remain anonymous.
Donations received in case of (ii) and (iii) above, often contain specific instructions for utilisation of the donated amount
for specific purposes e.g. for education of orphan children.
Required:
(a) Identify the inherent risks in the operations of AMF. (03 marks)
(b) Briefly discuss the effect of each of these risks on the audit of AMF. (03 marks)

Auditing – Case Studies Chapter 10 Understanding of Entity and Inherent Risk Assessment
CHAPTER TEN (CASE STUDIES)
INHERENT RISK ASSESSMENT
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Structure of the Case:
Inherent risk assessment through facts means performing inquiry, observation and inspection of
entity and identifying areas where there is potential of misstatement. In exam, you may be given
non-financial (i.e. descriptive) information about audit client and you will be required to identify
and describe audit risks i.e. areas where there is high risk and give explanation of risks. In advanced
questions, you may also be required to describe how you would address these audit risks.
Suggested Approach to Solve:
Read the paragraphs carefully and identify risk-factors (i.e. information which increases risk) one
by one. Also explain risk-factor by referring account balance and assertion impacted by risk.
(however, there is no need to explain whether identified risk is inherent, control or detection)
Examples of Frequently Asked Risks and Their Explanation
Risk Factor: Long-standing Inventory OR Technology/Fashion based Inventory OR Launch of new product by
competitor OR Decrease in selling price/sales:
Inventory may have become obsolete requiring write-down of inventory from cost to NRV. Therefore, Valuation and
Allocation assertion of Inventory is at risk.
Risk Factor: Client deals in significant imports and/or exports:
Some items may be in-transit at year end which may be wrongly included in or excluded from inventory. Therefore, cut-
off assertion of sales or purchases is at risk and consequently debtors and creditors may also be overstated or
understated.
Further, incorrect exchange rates may be used to translate into transactions into local currency. Therefore, accuracy of
Sales or Purchases is also at risk.
Risk Factor: Existence of precious and portable Inventory or Cash:
Inventory or Cash may be misappropriated by dishonest individuals. Therefore, Existence assertion of inventory or cash
is at risk.
Risk Factor: “Standard costing” or “S.P less profit margin” method is used for Inventory valuation:
At year end, actual Cost may be different from standard cost/S.P less profit margin method. Therefore, Valuation and
Allocation assertion of inventory is at risk.
Risk Factor: Inventory is held at various locations OR Inventory is held with third party OR Physical count was
not done at balance sheet date:
It is difficult to determine correct amount of inventory at balance sheet date. Therefore, Existence and Completeness
assertions of inventory are at risk.
Risk Factor: Client has work-in-process inventory
It is difficult to determine correct cost of work-in-process because it involves estimation of stage of completion (which is
subjective); and absorption of overhead (which is complex). Therefore, Valuation and Allocation assertion of Inventory is
at risk.
1 By Muhammad Asif, ACA

Risk Factor: Dispute with debtors
It may be difficult to recover full amount from disputed debtor. Therefore, Valuation and Allocation assertion of Debtors is
at risk.
Further, if dispute arises with a major customer, there is also a risk that going concern assumption may not be
appropriate because future income stream is lost.
Further, if dispute arises because of malfunctioning of goods, inventory may also require provisioning. Therefore,
Valuation and Allocation assertion of inventory is also at risk.
Risk Factor: Long-standing Debtors OR Debtor experiencing financial difficulty OR Extension in Credit Period:
Poor debtors may exist from whom full recovery is not expected, and may require provisioning. Therefore, Valuation and
Allocation assertion of Debtors is at risk.
Risk Factor: Specialized/Customized inventory:
If customer cancels order or goes bankrupt, i
Risk Factor: Sales-based remuneration being paid to staff:
There is a risk that fake sales (particularly at year-end) or next-period’s sales may be recorded to earn sales-commission.
Therefore, Occurrence and Cut-off assertions of Sales are at risk.
Further, Goods may be sold to debtors with poor financial position, from whom full recovery is not expected. Therefore,
Valuation and Allocation assertion of Debtors is also at risk.
Risk Factor: Cash is received from sales at different phases (i.e. before delivery or after delivery):
Revenue may be recognized pre-mature (if cash received before delivery) or delayed (if cash received after delivery).
Therefore, there is a risk of Occurrence and Completeness assertions of sales.
Risk Factor: Significance Purchases of Fixed Assets during the year:
Directly attributable costs on acquisition may be incorrectly calculated. Therefore, Valuation and Allocation assertion of
fixed assets is at risk.
Risk Factor: Significance Disposals of Fixed Assets during the year:
Profit or loss on disposal may be incorrectly calculated. Therefore, Accuracy assertion of gain/loss on disposal of fixed
assets is at risk.
Risk Factor: Heavy Repair and Maintenance or Construction of fixed assets during the year:
There may be incorrect categorization of cost between Revenue and Capital Expenditure. Therefore, Classification
assertion of repair expense is at risk.
Further, all expenditures of project may not be recorded. Therefore, Completeness assertion of Repair Expense or Fixed
Assets is at risk.
Risk Factor: Destroyed OR Unused OR Under-utilized Fixed Assets:
Fixed assets may have been impaired. Therefore, Valuation and Allocation assertion of fixed assets is at risk.
Risk Factor: Revaluation of Fixed Assets:
Revaluation may be incorrectly calculated and recorded because it involves Subjectivity (e.g. determination of useful life)
and Complexity (e.g. deferred tax implication). Therefore, Valuation and Allocation assertion of fixed assets is at risk.
Risk Factor: Change in estimates of depreciation:
Change in useful life or residual value or method of depreciation may be unreasonable, to increase profit. Therefore,
Valuation and Allocation assertion of fixed assets is at risk.

Risk Factor: Goods sold over internet:
Internet sales may be recorded before risk and rewards are transferred because high level of sales return is expected on
such sales because of wrong specification, late delivery or dissatisfaction of customer. Therefore, Occurrence and Cut-off
assertion of Sales is at risk.
Risk Factor: Warranty on Sales:
Warranty may be incorrectly calculated because it involves estimation and complexity. Therefore, Accuracy assertion of
Warranty is at risk.
Risk Factor: Pending litigations and contingent liabilities (e.g. unfair dismissal of staff, or physical injury to staff
due to poor working conditions, physical injury to customers because of defective good):
There is a risk that disclosure or provision relating to litigation may not be appropriately recorded in financial
statements. Therefore, Completeness assertion of Liabilities and Disclosures is at risk.
If litigation relates to customer, there is also risk that amount receivable may not be fully recovered, Valuation and
Allocation of Debtors is at risk. If customer is major, there is also a risk that going concern assumption may not be
appropriate.
If dispute arises because of malfunctioning of goods, inventory may also require provisioning. Therefore, Valuation and
Allocation assertion of inventory is also at risk. If product is major, there is also a risk that going concern assumption may
not be appropriate.
Risk Factor: High turnover of workers:
There is a risk that payments may be made to ghost employees, or salaries expense may not be accurately or completely
calculated. Therefore, Occurrence, Accuracy and Completeness of Payroll expense is at risk.
Risk Factor: Intangible asset recognized by client (e.g. Capitalization of Development cost, brand name, web-site
development):
Intangible assets may not have met recognition criteria, or may be incorrectly valued because of subjectivity and
complexity in valuation (e.g. issue of useful life, issue of internal expenses). Therefore, Valuation and Allocation assertion
of Intangible Assets is at risk.
Risk Factor: Deferred tax asset is recognized by client:
Deferred tax asset may not have met recognition criteria (e.g. when future profit/sales are declining) or may be
incorrectly calculated because of complexity involved in calculation. Therefore, Valuation and Allocation assertion of
Deferred Tax Asset is at risk.
Risk Factor: Investigation by tax authorities:
Tax expense may be understated. Therefore, Completeness and Accuracy assertions of tax expense are at risk.
Risk Factor: Redundant workforce:
Compensation payable to redundant workforce may not be completely recorded. Therefore, Completeness assertion of
Provision for Redundancy is at risk.
Risk Factor: Loan from Bank:
Split of loan between current and non-current portion, and disclosures (e.g. charges on assets) may be inappropriately
included in financial statements. Therefore, Presentation and Disclosure assertions of loan are at risk.
Further, if default is made in debt-covenant requirements, , there is also a risk that bank may call-back entire loan and if
company does not have alternate source of financing, going concern assumption may not be appropriate.
Risk Factor: Reconciliations not being prepared (in bank, debtors, creditors, inventory):
There is an increased risk that errors may not be identified timely. Completeness, Valuation and Allocation, and Accuracy
assertions are at risk.
Risks at Financial Statement Level:
New/inexperienced staff in accounting and finance department:
Errors may occur in financial statements because of lack of experience.

Few/overburdened staff in accounting and finance department:
Errors may occur in financial statements because of lack of segregation of duties.
Finance department is working without financial controller (or IT department working without IT manager):
Staff may have some problems and without support from departmental head, errors may occur in financial statements
due to lack of knowledge and experience.
Introduction of new IT system:
Errors may occur during changeover process which may impact financial statements.
Sales/Operations being made at various distant locations:
Accuracy and Completeness of transaction in financial statements may be incorrect.
This is first year of audit of client (i.e. initial audit):
Audit risk is increased in first year of audit because it may be difficult to verify opening balances and auditor has limited
knowledge about entity.
Reduced reporting timetable:
Audit risk is increased as audit team will have less time and will be under-pressure in obtaining sufficient appropriate
audit evidence.
Prospective sale of business, OR Contingent remuneration of management or CEO with majority shareholding:
There is a risk of management bias to manipulate financial statements, to increase personal wealth of
management/shareholders.
Model Case Study From Examination Questions:
Case Study – First Example:
You are the audit supervisor of Seagull & Co and are currently planning the audit of your existing client, Eagle Heating Co
(Eagle), for the year ending 31 December 2014. Eagle manufactures and sells heating and plumbing equipment to a
number of home improvement stores across the country.
Eagle has experienced increased competition and as a result, in order to maintain its current levels of sales, it has
decreased the selling price of its products significantly since September 2014. The finance director has informed your
audit manager that he expects increased inventory levels at the year end. He also notified your manager that one of
Eagle’s key customers has been experiencing financial difficulties. Therefore, Eagle has agreed that the customer can take
a six-month payment break, after which payments will continue as normal. The finance director does not believe that any
allowance is required against this receivable.
In October 2014 the financial controller of Eagle was dismissed. He had been employed by the company for over20 years,
and he has threatened to sue the company for unfair dismissal. The role of financial controller has not yet been filled and
so his tasks have been shared between the existing finance department team. In addition, the purchase ledger supervisor
left in August and a replacement has been appointed in the last week. However, for this period no supplier statement
reconciliations or purchase ledger control account reconciliations were performed.
You have undertaken a preliminary analytical review of the draft year to date statement of profit or loss, and you are
surprised to see a significant fall in administration expenses.
Required:
Explain FIVE audit risks, and the auditor’s response to each risk, in planning the audit of Eagle Heating Co. (10 marks)
Suggested Solution:
Risk Factor: Decrease in selling price and Increase in inventory level at year end:

Risk Factor: Debtor experiencing financial difficulty and Extension in Credit Period:
Debtor facing financial difficulty may not pay full amount of debt, and may require provisioning. Therefore, Valuation and
Allocation assertion of Debtors is at risk.
Risk Factor: Threat by ex financial controller to sue company for unfair dismissal:
There is a risk that disclosure or provision relating to threatened litigation may be inappropriately recorded in financial
statements. Therefore, Completeness assertion of Liabilities and Disclosures is at risk.
Finance department is working without financial controller:
Risk Factor: Purchase ledger reconciliation not being performed:
There is an increased risk that errors in purchases and creditors may not be identified timely. Completeness, Valuation
and Allocation, and Accuracy assertions are at risk.
Risk Factor: Significant fall in admin expenses
Admin expenses are fixed in nature and do not change with sales. Significant decrease in admin expenses indicates
understatement or misclassification of admin expenses. Therefore, Completeness and Classification assertion of admin
expenses are at risk.
(Note for students: In this chapter, you are expected to learn only to identify and explain audit risks. Therefore, requirement
relating to auditor’s response to each risk will be discussed in chapter # 12 Substantive Procedures.)
Case Study – Second Example:
Abrahams Co develops, manufactures and sells a range of pharmaceuticals and has a wide customer base across Europe
and Asia. You are the audit manager of Nate & Co and you are planning the audit of Abrahams Co whose financial year end
is 31 January. You attended a planning meeting with the finance director and engagement partner and are now reviewing
the meeting notes in order to produce the audit strategy and plan. Revenue for the year is forecast at $25 million.
During the year the company has spent $2·2 million on developing several new products. Some of these are in the early
stages of development whilst others are nearing completion. The finance director has confirmed that all projects are likely
to be successful and so he is intending to capitalise the full $2·2 million.
Once products have completed the development stage, Abrahams begins manufacturing them. At the year end it is
anticipated that there will be significant levels of work in progress. In addition the company uses a standard costing
method to value inventory; the standard costs are set when a product is first manufactured and are not usually updated.
In order to fulfill customer orders promptly, Abrahams Co has warehouses for finished goods located across Europe and
Asia; approximately one third of these are third party warehouses where Abrahams just rents space.
In September a new accounting package was introduced. This is a bespoke system developed by the information
technology (IT) manager. The old and new packages were not run in parallel as it was felt that this would be too onerous
for the accounting team. Two months after the system changeover the IT manager left the company; a new manager has
been recruited but is not due to start work until January.
In order to fund the development of new products, Abrahams has restructured its finance and raised $1 million through
issuing shares at a premium and $2·5 million through a long-term loan. There are bank covenants attached to the loan, the
main one relating to a minimum level of total assets. If these covenants are breached then the loan becomes immediately
repayable. The company has a policy of revaluing land and buildings, and the finance director has announced that all land
and buildings will be revalued as at the year end.
The reporting timetable for audit completion of Abrahams Co is quite short, and the finance director would like to report
results even earlier this year.
Required:
Using the information provided, identify and describe FIVE audit risks and explain the auditor’s response to each risk in
planning the audit of Abrahams Co. (10 marks)

Suggested Solution:
Risk Factor: All development cost have been capitalized:
Some of the development cost may not have met recognition criteria. Therefore, Existence and Valuation and Allocation
assertions of Capitalized Development Cost are at risk.
Risk Factor: Significant level of work-in-process inventory
It is difficult to determine correct cost of work-in-process because it involves estimation of stage of completion (which is
subjective); and absorption of overhead (which is complex). Therefore, Valuation and Allocation assertion of Inventory is
at risk.
Risk Factor: “Standard costing” method is used for Inventory valuation:
At year end, actual Cost may be different from standard cost, specially as it is not updated periodically. Therefore,
Valuation and Allocation assertion of inventory is at risk.
Risk Factor: Inventory is held at various locations:
It is difficult to determine correct amount of inventory at balance sheet date. Therefore, Existence and Completeness
assertions of inventory are at risk.
Risk Factor: Introduction of new IT system:
Errors may occur during changeover process which may impact financial statements.
Risk Factor: IT department working without IT manager:
Further, if default is made in debt-covenant requirements, , there is also a risk that bank may call-back entire loan and if
company does not have alternate source of financing, going concern assumption may not be appropriate.
Risk Factor: Revaluation of Fixed Assets:
Revaluation may be incorrectly calculated and recorded because it involves Subjectivity (e.g. determination of useful life)
and Complexity (e.g. deferred tax implication). Therefore, Valuation and Allocation assertion of fixed assets is at risk.
Risk Factor: Reduced reporting timetable:
Audit risk is increased as audit team will have less time and will be under-pressure in obtaining sufficient appropriate
audit evidence.
Case Study – Third Example:
You are the audit manager of the Educational University (EU) for the year ended 31 December 2015. EU has a student
base of 2,500 students. It follows a policy of receiving 50% of the fees at the start of the semester and 50% in the middle
of the semester. However, 10% discount is allowed to those students who pay the entire amount in advance. The cost of
course material is included in the fees. The semester starts in December and June each year. You have noticed that 30% of
the students who were registered in December 2015 had not claimed the course material till 31 December 2015.
Required:
Discuss the audit risks in the above scenario and how you would deal with them. (07 marks)
(CAF 09, Spring 2016)
Suggested Solution:
Risk Factor: Tuition Fee received in Advance:
Tuition fee is being received in advance from students (i.e. before providing services). There is a risk that advance income
received in December 2015 (for which services will be provided in 2016) may be recorded as income for 2015 (instead of
liability). Therefore, cut-off assertion of Revenue is at risk.

Risk Factor: Cost of course material is included in fees:
Providing tuition is a service activity whereas selling course material is a trading activity, so both must be reported as
separate line item. If revenue for both is received combined, there is a risk that revenue is also recorded on combined
basis. Therefore, Classification assertion of revenue is at risk.
Risk Factor: 30% of students have paid for course fee but did not claim course material:
If course material has not been provided at year end, then related receipt should be recorded as advance income (i.e. a
liability). There is a risk that client has recorded it as income in current period. Therefore, Occurrence assertion of
revenue is at risk.
Risk Factor: Discount is given to students paying full fee in advance:
Discount may not be appropriately classified. Therefore, Classification assertion of discount allowed is at risk.

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Structure of the Case:
Inherent risk assessment through figures means performing analytical procedures and identifying
areas where there is potential of misstatement. Two types of cases are possible in exam:
1. You are given Rations/Percentages and are required to identify risks, or
2. You are given Extracts of Financial Statements and are required to identify risks.
In advanced questions, you may also be required to describe how you would address these audit risks.
Suggested Approach to Solve:
1. If you are given ratios/percentages, then you have to directly identify risks.
2. If you are given extracts of financial statements, then first you have to calculate
ratios/percentages, and then you have to identify risks.
Examples of Frequently Asked Risks and Their Explanation
Risk Factor: Significant increase/decrease in Sales compared to last year (i.e. current year’s sales/last year’s
sales * 100)
Significant increase in sales indicates overstatement of sales. Therefore, Occurrence and Cut-off assertions of Sales are at
risk.
Significant decrease in sales indicates understatement of sales. Therefore, Completeness assertion of sales is at risk.
Further, a decrease in sales due to decrease in demand or sale price of products also indicates inventory may have
become obsolete requiring write-down of inventory from cost to NRV. Therefore, Valuation and Allocation assertion of
Inventory is also at risk.
Risk Factor: Significant increase/decrease in Cost of Sales (as %age of sales) as compared to last year (i.e. Cost of
Sales/Sales * 100 for both year)
Significant increase in %age of cost of sales indicates overstatement of Purchases. Therefore, Occurrence and Cut-off
assertions of Purchases are at risk. Further, it may also indicate overstatement of Overheads and understatement of
Closing stock.
Significant decrease in %age of cost of sales indicates understatement of Purchases. Therefore, Completeness assertion of
Purchases is at risk. Further, it may also indicate understatement of Overheads and overstatement of Closing stock.
Exam Tip
If you are given GP ratio in exam, remember that it includes effect of both Sales and Cost of Sales.
Therefore, your risk assessment through GP ratio should cover both.
However, there will be no risk in sales if increase/decrease is due to launch of new
products or discontinuance of existing products.
However, there will be no risk in cost of sales if increase/decrease is due to change in
cost of inputs or change in production technology.

Risk Factor: Significant increase/decrease in Admin expenses as compared to last year (i.e. current year’s admin
expense/last year’s admin expense * 100)
Admin expenses are fixed in nature and do not change with sales.
Significant increase in admin expenses indicates overstatement or misclassification of admin expenses. Therefore,
Occurrence and Classification assertion of admin expenses are at risk.
Significant decrease in admin expenses indicates understatement or misclassification of admin expenses. Therefore,
Completeness and Classification assertion of admin expenses are at risk.
Risk Factor: Significant increase/decrease in Selling/Operating Expenses (as %age of sales) as compared to last
year (i.e. Selling Expenses/Sales * 100 for both year)
Significant increase in selling/operating expenses indicates overstatement or misclassification of selling/operating
expenses. Therefore, Occurrence and Classification assertion of selling/operating expenses are at risk.
Significant decrease in selling/operating expenses indicates understatement or misclassification of selling/operating
expenses. Therefore, Completeness and Classification assertion of selling/operating expenses are at risk.
Risk Factor: Significant increase/decrease in Depreciation Expenses (as %age of tangible fixed assets) as
compared to last year (i.e. Depreciation Expense/Tangible Fixed Assets * 100 for both year)
Significant increase in depreciation expenses indicates overstatement of depreciation expenses. Therefore, Accuracy
assertion of depreciation expenses is at risk.
Significant decrease in depreciation expenses indicates understatement of depreciation expenses.. Therefore,
Completeness assertion of depreciation expenses is at risk.
Risk Factor: Significant increase/decrease in Interest/Finance charges (as %age of Borrowings/Loans) as
compared to last year (i.e. Interest/Loans * 100 for both year)
Significant increase in finance charges indicates overstatement of finance charges. Therefore, Occurrence and Accuracy
assertions of finance charges are at risk. It may also indicate understatement of borrowings.
Significant decrease in finance charges indicates understatement of finance charges. Therefore, Completeness and
Accuracy assertions of finance charges are at risk. It may also indicate overstatement of borrowings.
Risk Factor: Significant increase/decrease in Debtors’ Turnover Ratio in days compared to last year (i.e.
Debtors/Sales * 360 for both year)
Significant increase in debtors’ turnover days indicates that debtors may be overstated e.g. fake debtors may exist or poor
debtors may exist from whom full recovery is not expected. Therefore, Existence and Valuation and Allocation assertions
of Debtors are at risk.
Significant decrease in debtors’ turnover days indicates that debtors may be understated. Therefore, Completeness
assertion of debtors is at risk.
However, there will be no risk in selling/operating expenses if increase/decrease is
due to change in number of employees, advertisement and promotional schemes.
However, there will be no risk in finance charges if increase/decrease is due to change
in interest rates during the year.

Risk Factor: Significant increase/decrease in Inventory’ Turnover Ratio in days compared to last year (i.e.
Inventory/ Cost of Sales* 360 for both year)
Significant increase in inventory turnover days indicates that Inventory may be overstated e.g. fake inventory may exist,
or there may be incorrect valuation of inventory, or inventory may have become obsolete requiring write-down of
inventory from cost to NRV. Therefore, Existence and Valuation and Allocation assertions of Inventory are at risk.
Significant decrease in inventory turnover days indicates that inventory may be understated e.g. some inventory may be
omitted, or there may be incorrect valuation. Therefore, Completeness and Valuation and Allocation assertions of
Inventory are at risk
Risk Factor: Significant increase/decrease in Creditors’ Turnover Ratio in days compared to last year (i.e.
Creditors/Purchases * 360 for both year)
Significant increase in creditors’ turnover days indicates that creditors are overstated. Therefore, Existence assertion of
Creditors is at risk. It also indicates that company is having financial problems and is unable to pay creditors timely.
Significant decrease in creditors’ turnover days indicates that creditors may be understated. Therefore, Completeness
assertion of Creditors is at risk.
Risk Factor: Significant increase/decrease in current ratio compared to last year (i.e. Current Assets/Current
Liabilities for both year)
Significant increase in current ratio indicates overstatement of current assets or understatement of current liabilities.
Therefore, Existence assertion of current assets and Completeness assertion of current liabilities are at risk.
Significant decrease in current ratio indicates understatement of current assets or overstatement of current liabilities.
Therefore, Completeness assertion of current assets and Existence assertion of current liabilities are at risk.
Risk Factor: Ratios indicating liquidity or going concern problems of entity:
1. Decrease in Current Ratios
2. Decrease in NP ratio.
3. Decrease in interest coverage ratio (also called Times Interest Earned).
4. Increase in borrowings.
However, there will be no risk in inventory if increase/decrease in days is due to change
in methods of production and change in inventory levels to support future sales.
However, there will be no risk in creditors if increase/decrease in days is due to change
in credit period by suppliers.
Exam Tip
Risk Assessment through figures is to be done in the same order as given above i.e. first specific ratio
and then general ratios.
Exam Tip
Turnover ratios (e.g. debtors /inventory/creditors turnover ratios) can be calculated in two ways i.e. in
times or in days. You are advised to always calculate and interpret these ratios in days.

Model Case Study From Examination Questions:
Case Study – First Example
In the planning phase of the audit of Dynamic Limited for the year ending 30 June 2012, you have calculated the following
ratios from the management accounts of the company for the eight months ended 29 February 2012:
Eight months period
ended
29 February 2012
Year ended
30 June 2011
Year ended
30 June 2010
Gross profit percentage 35% 40% 40%
Inventory turnover days 120 105 78
Current ratio 1.5 2.3 2.6
Quick asset ratio 0.78 1.6 1.7
Times interest earned 0.91 1.67 2.1
Debtors turnover days 132 86 68
Required:
Identify the prospective audit risks which the auditor should consider while planning the audit. (09 marks)
Suggested Solution:
Risk Factor: Decrease in Gross Profit Percentage:
Analysis of GP ratio can be subdivided into two aspects i.e. Sales and Cost of Sales.
1. Decrease in GP ratio indicates understatement of sales. Therefore, Completeness assertion of sales is at risk.
2. Decrease in GP ratio also indicates overstatement of Purchases. Therefore, Occurrence and Cut-off assertions of
Purchases are at risk. Further, it may also indicate overstatement of Overheads and understatement of Closing
stock.
Risk Factor: Increase in Inventory turnover days:
Significant increase in inventory turnover days indicates that Inventory may be overstated e.g. fake inventory may exist,
or there may be incorrect valuation of inventory, or inventory may have become obsolete requiring write-down of
inventory from cost to NRV. Therefore, Existence and Valuation and Allocation assertions of Inventory are at risk.
Risk Factor: Increase in Debtors turnover days:
Significant increase in debtors’ turnover days indicates that debtors may be overstated e.g. fake debtors may exist or poor
debtors may exist from whom full recovery is not expected. Therefore, Existence and Valuation and Allocation assertions
of Debtors are at risk.
Risk Factor: Decrease in Current ratio:
Significant decrease in current ratio indicates overstatement of current liabilities. Therefore, Existence assertion of
current liabilities is at risk. Further, this also indicates that entity is facing liquidity or going concern problems.
Risk Factor: Liquidity problems of entity:
Current ratio, quick asset ratio, times interest ratio and GP ratios are decreasing, which indicates company’s liquidity
position is worsening. Therefore, there is a risk of management bias in financial statements (of next four months) to
present best-view of financial statements, to increase personal wealth of management/shareholders.

Case Study – Second Example
You are the Audit Manager of Mustafa and Company, Chartered Accountants, responsible for the audit of Standard
Home Appliances Limited, a listed company.
Extracts from the company’s financial statements are presented below:
30-Sep-2012 30-Sep-2011
Income statement ----------Rs. in million---------
Revenue 1,190 1,174
Gross profit 509 537
Operating profit 242 227
Finance charges (77) (69)
Profit before tax 165 158
Statement of financial position
Property, plant and equipment 1,054 833
Intangible assets 140 100
Inventory 423 260
Trade receivables 417 250
Cash and bank balances 29 54
Total assets 2,063 1,497
Equity and liabilities
Share capital
1 000 1 000
Retained earnings 218 233
Long-term borrowings 277 50
Liabilities against assets subject to finance lease 180 -
Bank overdraft 185 52
Trade and other payables 203 162
Total equity and liabilities 2,063 1,497
During the year, the company has introduced various products based on latest technologies. These new products
are being manufactured on a new plant which has been acquired under a lease agreement for a period of four years.
The plant commenced operations on 01 January 2012. The useful life of the plant is 5 years.
Intangible assets represent cost of software installed and designs which have been acquired from a renowned
multinational company.
Required:
Identify and evaluate the audit risks in the above situation. (12 marks)
(CA Final, Winter 2012)
Suggested Solution:
Risk Factor: Stagnant Revenue despite launch of various new products
There has been only 1% increase in sales (1,190/1,174) despite launch of various new products this year based on latest
technologies. It indicates sales may be understated. Therefore, Completeness assertion of sales is at risk.
Further, it also indicates that new products have not been successful or demand for existing products have decreased, and
indicates inventory may have become obsolete requiring write-down of inventory from cost to NRV. Therefore, Valuation
and Allocation assertion of Inventory is also at risk.
Further, new plant purchased for new products may also have become impaired as its value in use has decreased if new
products are not successful.
Risk Factor: Increase in Cost of Sales (as %age of Sales)
Increase in cost of sales (681/1,190= 57.23% as compared to last year 637/1,174= 54.23%) may be because of

depreciation of new plant, but it also indicates overstatement of purchases or overheads. Further, it may indicate
understatement of closing stock.
Risk Factor: Decrease in operating expenses(as %age of Sales)
Decrease in operating expenses (267/1,190 = 22.4% as compared to last year 310/1,174 = 26.4%) indicates
understatement of operating expenses (specially advertisement and sales related cost should increase when new
products are launched). It also indicates misclassification between operating expenses and cost of sales.
Risk Factor: Decrease in finance charge (as %age of borrowings)
Decrease in finance charge (77/642=11.99% as compared to last year 69/102=67.65%) indicates understatement of
finance charges. Therefore, Completeness and Accuracy assertions of finance charges are at risk. It may also indicate
overstatement of borrowings.
Risk Factor: Increase in Inventory Turnover Days:
Increase in inventory turnover days (423/1,190*360 = 128 days as compared to last year 260/1,174*360 = 80 days)
indicates that Inventory may be overstated e.g. fake inventory may exist, or there may be incorrect valuation of inventory,
or inventory may have become obsolete requiring write-down of inventory from cost to NRV. Therefore, Existence and
Valuation and Allocation assertions of Inventory are at risk.
Risk Factor: Increase in Debtors Turnover Days:
Increase in debtors turnover days (417/1,190*360 = 126 days as compared to last year 250/1,174*360 = 77 days)
indicates that debtors may be overstated e.g. fake debtors may exist or poor debtors may exist from whom full recovery is
not expected. Therefore, Existence and Valuation and Allocation assertions of Debtors are at risk.
Risk Factor: Intangible assets recognized and purchased by company:
Intangible assets may not have met recognition criteria, or may be incorrectly valued because of subjectivity and
complexity in valuation (e.g. issue of useful life, issue of internal expenses). Therefore, Valuation and Allocation assertion
of Intangible Assets is at risk.
Risk Factor: Increased level of borrowing:
Deteriorating current ratio and increased level of borrowing which indicates company’s liquidity position is worsening.

Case Study – Third Example
You are the audit senior of Rhino & Co and you are planning the audit of Kangaroo Construction Co (Kangaroo) for the
year ended 31 March 2013. Kangaroo specialises in building houses and provides a five-year building warranty to its
customers. Your audit manager has held a planning meeting with the finance director. He has provided you with the
following notes of his meeting and financial statement extracts:
Kangaroo has had a difficult year; house prices have fallen and, as a result, revenue has dropped. In order to address this,
management has offered significantly extended credit terms to their customers. However, demand has fallen such that
there are still some completed houses in inventory where the selling price may be below cost. During the year, whilst
calculating depreciation, the directors extended the useful lives of plant and machinery from three years to five years.
This reduced the annual depreciation charge.
The directors need to meet a target profit before interest and taxation of $0·5 million in order to be paid their annual
bonus. In addition, to try and improve profits, Kangaroo changed their main material supplier to a cheaper alternative.
This has resulted in some customers claiming on their building warranties for extensive repairs. To help with operating
cash flow, the directors borrowed $1 million from the bank during the year. This is due for repayment at the end of 2013.
Financial statement extracts for year ended 31 March
DRAFT ACTUAL
2013 2012
$m $m
Revenue 12.5 15.0
Cost of sales (7.0) (8.0)
Gross profit 5.5 7.0
Operating expenses (5.0) (5.1)
Profit before interest and taxation 0.5 1.9
Inventory 1·9 1·4
Receivables 3·1 2·0
Cash 0.8 1·9
Trade payables 1·6 1·2
Loan 1·0 –
Required:
Using the information above:
(i) Calculate FIVE ratios, for BOTH years, which would assist the audit senior in planning the audit; and (05 marks)
(ii) Using the information provided and the ratios calculated, identify and describe FIVE audit risks and explain the
auditor’s response to each risk in planning the audit of Kangaroo Construction Co. (10 marks) (ACCA F8 – June 2013)
Suggested Solution:
(i)
Ratio Formula Calculation
2013 2012
Gross Profit Ratio G.P. / Sales 44.0% 46.7%
Net Profit Ratio N.P./Sales 4.0% 12.7%
Inventory Turnover Ratio (days) Inventory/Cost of Sales * 360 97.7 63.0
Debtors Turnover Ratio (days) Debtors/Sales * 360 89.3 48.0
Current Ratio Current Assets/Current Liabilities 2.2 4.4
Quick Asset Ratio Current Assets - Inventory /Current Liabilities 1.5 3.3

(ii)
Risk Factor: Fall in demand of houses, Fall in price of houses, Increase in Inventory turnover days:
Risk Factor: Extension in credit terms to customers and Increase in debtors’ turnover days
Poor debtors may exist from whom full recovery is not expected. Therefore, Valuation and Allocation assertion of Debtors
is at risk.
Risk Factor: Change in useful life of fixed assets:
Increase in useful life from 3 to 5 years may be unreasonable, to increase profit. Therefore, Valuation and Allocation
assertion of fixed assets is at risk.
Risk Factor: Management’s annual bonus based on target profit:
There is a risk of management bias to manipulate financial statements, to increase personal wealth of management.
Risk Factor: Shift to cheap supplier and increase in claims for warranty:
Warranty may be incorrectly calculated because it involves estimation and complexity. Therefore, Accuracy assertion of
Warranty is at risk.
Risk Factor: Liquidity problems of entity:
Current ratio, and quick asset ratio are decreasing, which indicates company’s liquidity position is worsening.

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