International Standards on Auditing (ISA) 315 Identifying and Assessing The Risk of Material Misstatement Through Understanding The Entity and Its Environment states that the auditor is response to identify and assess the risk of material misstatements in financial statements, through understanding the entity and its environment, including the entity’s internal control (International Federation of Accountants, 2009). For BH Sdn Bhd, the risk assessment can be done by assessing the risk of material misstatements on both financial statements and assertion levels, and assessing on whether there is risk that required special audit consideration.
Risk of Material Misstatement
Under the risks of material misstatement, it comprises risk of material misstatement at financial statement level and assertion level for classes of transactions, amount balances and disclosures.
Risk of Material Misstatement on Financial Statement Level
For risks of material misstatements at financial statement level, it refers to the risk relate to the financial statement as a whole and potentially affect many assertions (International Federation of Accountants, 2009). The risk does not be necessarily to be identifiable in any assertions, but it may some how increase the chances of misstatement in assertion level. Further, the risks of material misstatements at the financial statement level are closely related to the internal control system within the entity.
In BH Sdn Bhd, the arise of risk of material misstatements on financial statements is due to the deficient internal control system within the entity. The finance department comprises an account executive and a finance manager, which responsible for record keeping and authorization respectively. However, both of these position are comprised under finance department, in order words the finance departments taking up two of the duties under an efficient internal control system. Under the concept of segregation of duties, a department shall not be taken care of more than one duty, in order to ensure efficiency in internal control system (Ghosn, n.d.). Therefore, due to the lack of segregation of duties within the company's internal control system, it lowers down the company’s internal control level, and increases the risk of omission and fraudulent accounting practices within the company.
Risk of Material Misstatement on Assertion Level
An audit assertion is defined as claims or representations made by the management of the company responsible for the preparation of the financial statements regarding the appropriateness of various elements of financial statements and disclosures (Accounting-Simplified, n.d.). Risk of material misstatement on assertion level refers to the potential chances of misstatements on classes of transactions, account balances and presentation and disclosure (International Federations of Accountants, 2009). These assertions include completeness, rights and obligations, valuation and allocation, existence, occurrence, accuracy, classification and cutoff.
Completeness
Completeness covers all types of assertions, which are classes of transactions, account balances and presentation and disclosure. For classes of transactions, completeness refers to all transactions that occurred during the period has been record (Accounting Concern, n.d.). While for completeness stated under account balances is about all assets, liabilities and equity interest that should have been included in the ending balances have been included (Accounting Concern, n.d.). Further, for presentation and disclosure, completeness defines that all disclosures that should have been included in the financial statements have been included (Accounting Concern, n.d.).
Due to the issue of lack of segregation of duties in BH Sdn Bhd, the risk of material misstatements on completeness for classes of transactions rises. From the information provided, the director is the one who receives the claim, but at the same time the subordinate of the directors, which is the finance manager is the one who approve the claims. From the view of finance manager, to secure his job, he will approve all the claims submitted by the director even without sufficient claims descriptions and evidences, such as official receipts.
Based on the information given, no physical stock take is performed at third parties ware hare as at end of the financial year. This has increases the uncertainty on completeness of inventories account balances. This is because by referring to the delivery orders and invoices received from the suppliers, it do not shows the actual volume of inventories received by the third party’s ware house. The volume of actual received inventories may be lesser or more than the volume stated in the transaction documents.
There is also potential risk of misstatements on the completeness of the presentation and disclosure for the financial statements presented. From the past audit experiences, BH Sdn Bhd financial statements involve many audit adjustments. Hence, it is potentially that the account personnel did not brought down the adjusted figures for each accounts during the beginning of the new financial year.
Valuation
Valuation is covered under both account balances and presentation and disclosure. For account balances, valuation refers to all elements presented in the financial statements is recorded at an appropriate amount and any resulting valuation or allocation are appropriately allocated (International Federation of Accountants, 2009). While for presentation and disclosure, valuation defines that financial and other information are disclosed fairly and at appropriate amount (International Federation of Accountants, 2009).
Refers to the issue of no physical stock take has been performed in third party’s ware house, it increases the risk of material misstatements on valuation under account balances category. The inventories in third party warehouse may not be stored appropriately and there is damage on the inventory, which later leads to an impairment of the inventory, lowers down the value of the inventory.
Accuracy
Accuracy is an audit assertion related to classes of transactions and presentation and disclosure. Under classes of transactions, amount or other data of transactions and events are recorded appropriately (ACCA Global, 2015). Further, for presentation and disclosure, accuracy is focusing on financial and other information are disclosed at a fairly and appropriate amount (ACCA Global, 2015).
Under classes of transactions, the risk of misstatements for the accuracy of the amount of transaction will be rose due to the lack of efficient internal control system. The claims from director are directly authorized by finance manager, which there is no other parties involved in verifying the claims, hence there may be inappropriate claims being passed and recorded in company’s books of accounts.
Due to the lack of segregation of duties, the will be a risk of misstatements on accuracy for presentation and disclosure. Since both record keeping and authorization duties are taken care by the finance department, the financial department may faced omission in transferring figures from book of account to financial statements in the preparation of financial statements process.
Cutoff
Cutoff only involves in classes of transaction, which the transactions has been recorded in the correct accounting period, especially for the transactions incurred nearly before the end of the period or the starting of a new period (Accounting-Simplified, n.d.).
From the past audit experience for BH Sdn Bhd, there are many cut-off issues on the revenue. This shows that there is higher risk on misstatements on cutoff for the amount of revenue recorded. In such, BH Sdn Bhd may have recorded the sales in the beginning of year 2017 in the total revenue for fiscal year 2016. Or accounting personnel in BH Sdn Bhd may have recognized the sales made in the end of year 2016 in the fiscal year of 2017.
Occurrence
Occurrence is one of the audit assertions that cover classes of transactions and presentation and disclosure. In such, occurrence defines that all transaction recorded and disclosed in the financial statements have occurred and related to the entity (Accounting-Simplified, n.d.).
The issue that leads to incurrence of risk of misstatement for occurrence under classes of transactions will be the finance manager authorizes the claims from director. The finance department may misstate the claims that have no relation to the entity in the financial statements.
Existence
Existence is an audit assertion that focuses on the account balances. Existence is about the presence of the assets, liabilities and the equity balances at the end of the accounting period (Accounting-Simplified, n.d.).
Based on the information, there is no physical stock take had been done in third party warehouse, which later lead to an incurrence of the risk of misstatements on the existence of inventories on account balances. In such, the volume of inventory recorded in the books of accounts may potentially different from the actual inventories hold by the company in the third party warehouse as third party my lost some of the inventory without knowing by the company.
Risk that Required Special Audit Consideration
The risk that required special audit consideration is a significant risk. A significant risk is defined as an identified and assessed risk of material misstatements that, in the auditor’s judgment requires special audit consideration (International Federation of Accountants, 2009). To identify whether there is significant risk, the auditor need to consider the following criteria:
(i) Whether the risk is a risk of fraud;
(ii) Whether the risk is related to recent significant economic, accounting or other developments and, therefore, requires specific attention;
(iii) The complexity of transactions;
(iv) Whether the risk involves significant transactions with related parties;
(v) The degree of subjectivity in the measurement of financial information related to the risk, especially those measurements involving a wide range of measurement uncertainty; and
(vi) Whether the risk involves signify transactions that are outside the normal course of business for the entity, or that otherwise appear to be unusual (International Federation of Accountants, 2009).
Risk of Fraud
Due to the lack of segregation of duties, there is a risk of fraudulent accounting practices undergoing within the finance department of BH Sdn Bhd. The finance department comprises both authorization and record keeping duties. Hence, there is a risk the finance department may be involving in creative accounting practices in order to reduce the tax amount for the accounting period.
Further, referring to the information provided, significant claims by the directors are approved by the finance manager, but at the same time finance manager works directly under the director. In an efficient internal control system, a director is responsible for the custody of assets. For BH Sdn Bhd, the finance department and the director comprise authorization, record keeping and custody process. Since there is no other party involved in the process of verifying the claims submitted by the directors, there is a risk that the director and finance department collaborate in inflated the claims amount or passing such claims that has no related to the company. For example, dining expenses by the director’s family is being submitted to the company for entertainment claims. Or from another point of view, since the finance managers reports to director directly and claims by the director are approved by the finance manager, the director may have pressures the finance manager in approving the claims submitted.
Risk Related To Significant Economic Development
BH Sdn Bhd has lost a major customer contributes to about 65% to the total annual revenue during the last quarter of 2016. Even though only lost the customer for not more than 4 months in year 2016, however the effect is clearly shows in the balance sheet as at 31 December 2015 of the company. In such, the retained earnings drops from RM 1,660,000 in year 2015 to an accumulated losses amounted RM870,000 in year 2016. Therefore, for year 2017, BH Sdn Bhd has risk to face further losses and going concern issue arises.