Auditing Process of Aerospace Lighting Inc - Case Study Example

?AUDITING Table of Contents Table of Contents 2 Introduction 3 Client Business Risks 3 Auditor’s Business Risk 6 Audit Risks 7 Inherent Risk: 8 2.Control Risk: 9 References 11 Introduction Various important and critical relationships are created through audit process which involves many parties. One of such important relationship is between the audit farm or the auditor and the audit client. The potential risk involved in the association with a certain audit client asks for an audit farm to decide on whether to continue with the existing client or not. This type of risk is known as engagement risk. The probabilities of different loss or damages that can be caused due to this type of risk can be a financial loss, loss of reputation, and ultimately leading to the downfall of the audit farm. Engagement risks can further be subdivided into three types of risks, namely 1) Client’s business risks, 2) Auditor’s business risk and 3) Audit risk. In the cited case of Aerospace Lighting Inc. (ALI) there are several audit issues related to engagement risks. All those audit issues involved with ALI and its impact on the financial statements and the audit process have been discussed here. ALI is a Chicago based company which is involved in the business of providing cabin lighting system to its clients in aerospace industry. There has been a change in ALI’s business strategy and its external auditors. This study entails about the different business risks associated with ALI and the corresponding audit issues. Client Business Risks Business risk can be defined as the probability that a given company will make less profit than what has been anticipated or there is a possibility that the company will make a loss instead of profit. Several factors influence business risks, like cost of inputs, volume of sales, price per unit, government policies and so on and so forth. The validity of items in financial statements of a company can be evaluated by an auditor based on certain factors. They are: knowledge of business risks associated with the business activities followed by the client, structure of the organization, internal and external environment of the business concern and the interactions between them (Bell et al. 1). Business risk methodology of audit process includes some of the following key points: 1) Developing an understanding about the process of risk management in the organization. 2) Developing an understanding about the risks involved in the business of the organization. 3) The risks which are identified give an idea about its expected impact on the financial statements. 4) Assessment of the control system about how much efficiently it manages risk (Rittenberg 121-123). In ALI’s case, various factors which have an impact on client’s business risks can be subdivided into three headings, namely management, entity and industry. A review of the previous auditor’s report and views of the Chief Financial Officer (CFO) are available and can be used as good audit evidence. CAS 620 relates to the decision of an auditor to use the work of an auditor’s expert. CAS 500 provides the necessary requirements and guidance to auditors regarding audit evidence. Consultant advice is also a good option in this case which is explained in CAS 220 (Financial Reporting & Assurance Standards Canada 1-8). Hence, regarding client’s business risks, following evidences can be considered as being the business risks involved in ALI: 1) Management: Firstly, regarding management of ALI, its integrity is the key. Certain evidence that ALI is not loyal to its parent German company named BmG can be inferred from the case. ALI’s management is only concerned about the financial performance of the company. While achieving its financial target, ALI calls for a strategy involving rapid growth of the company. ALI is not concerned much about reporting BmG regarding the means adopted by them to achieve its target. Here lies the business risk in the part of ALI’s management. There is a high probability that ALI can restore to unfair means to achieve its target and may not report the same to BmG. This may affect the financial statements too which may not properly address the issues regarding the risks involved in attaining high profit figures mentioned in the financial statements. 2) Entity: ALI as a business entity is faced with several business risks too. In the cited case, there is one such evidence where prior to ALI adopting the new business strategy of rapid expansion of its business, it had limited customer base. Bombardier was the only client of ALI. Thereafter, with the new strategy being adopted ALI managed to get three more clients namely, Boeing, Lockheed Martin and Raytheon in quick time. This calls for a client business risk and can have an adverse effect on the audit planning if not considered with due care. A proper audit procedure must be formulated to address this issue in the audit about the details of the contracts of ALI with its clients. Next there is also evidence of ALI facing difficulties in meeting its debt obligations. ALI is also facing problem in fulfilling the prior conditions of maintaining its sound liquidity condition regarding its debt obligations. This again adds to the existence of business risk involved in ALI. It can have adverse effect on the representation of financial statements as the current assets and current liabilities figures may be manipulated to conform to the required current ratio by its lenders. 3) Industry: Various factors prevailing in the aerospace industry can add to business risk of ALI. As mentioned in the case, ALI was set to increase its US aerospace contracts to increase its revenue. There is a high competition amongst the suppliers of aerospace industry, which adds to the business risk of ALI. With ALI being able to increase its US contracts in quick time, it meant that entry barrier to aerospace industry is too low. This is also a business risk for ALI. This can affect the audit process and subsequently the financial statements if the auditor does not look for proper evidence regarding the pricing of contracts made by ALI with its newly acquired clients. Auditor’s Business Risk Auditor business risk can be defined as the risk in the part of auditor’s business after the auditor report has been done. In relation to examining and filing an audit report about the financial statements of an organization, the auditor is exposed to the risk of loss or affliction of his professional auditing practice. These risks can arise from negative publicity, litigation or other incidents. This exposure to risk is prevalent even though the auditor report has been prepared in conformation with the Generally Accepted Auditing Standards (GAAS) and Canadian Auditing Standards (CAS) and the auditor might have made appropriate reporting of the items in the financial statements (Colbert, Luehlfing, and Alderman “Engagement Risk Defined”). There are some instances in ALI’s case which can add to auditor’s risk. One such instance is the change of external auditors of BmG who were responsible for auditing BmG and its subsidiaries including ALI. BmG mentioned the inability of the previous auditor to properly address the business risks involved with BmG and its subsidiaries as the reason behind such changes. This evidence adds to auditor’s risk for ALI. ALI’s share of ownership with GlueCo was not mentioned in the financial statements. This can add to auditor’s risk if ALI requires financial statements to be prepared without mentioning its interest on GlueCo. Hence, it can have an adverse effect on the financial statements because the investment activities of ALI mentioned in the financial statements may not give a true and fair view about the company affairs regarding its investment activities. Moreover, auditor may be skeptical about its reputation of being the auditor of ALI because of the recent incident of change of external auditors. Audit Risks Audit risks can be defined as the risk of the auditor accepting any misstatements present or omissions of certain facts which are material in the financial statements of the company which is already audited (Fragniere and Sullivan 104). Undiscovered error or fraud leads to material misstatements. Hence audit risk is the risk which results in developing an opinion about the financial statements of a company by the auditor which is not appropriate. Audit risk based methodology of auditing can be said to have been evolved from the systems and vouching process of auditing. This approach cannot be regarded as a completely new method of auditing but a modification of a previously existing approach. This risk based method of conducting an audit process is a quite effective and efficient approach (Turley 234). CAS 570 talks about the inability of an organization to continue as a going concern. Issues related to liquidity risks and credit risks associated with the organization are needed to be addressed in details by the corresponding auditors. CAS 320 speaks about the concept of materiality while planning for an audit or performing the audit procedures. Performance materiality is a key term used here which implies that materiality of the financial statements as a whole must not exceed the amounts which are set by the auditor. CAS 450 takes care of the effects of misstatements which were uncorrected in earlier years on being material to the present audit procedure. Audit Risk comprises of the following main components: 1. Inherent Risk: It is the risk of certain transactions being susceptible to material misstatement in the financial statements. It may occur either individually or in combination with other types of transactions which are materially misstated. These types of risks may be prevalent in organizations in spite of having internal control systems. CAS 315 is related to the compliance procedures for auditors to combat inherent risk (Financial Reporting & Assurance Standards Canada 2). In ALI’s case there are certain evidences of transactions being susceptible to material misstatement in the financial statements. Such evidences and its possible impacts on financial statements are as follows: a. With ALI resorting to the strategy of rapid expansion and getting three new US aerospace contracts, as mentioned earlier, there is an inherent risk in the policies followed by these US companies. They have the policy of providing single check to ALI for its supplies in every 55 days. Hence, ALI’s financial statements are susceptible to material misstatement of including these receipts from the US clients as receivables in the financial statement. There is a risk of changes in the actual amounts received by ALI from these clients. b. Previously there had been a loss due to fire in one of the leased plants of ALI at Milwaukee and ALI had filed a claim of $6.8 million with the corresponding insurer, but the final claim amount to be received by ALI is yet to be settled. The financial statements of ALI still show the existence of the lost plant. The book value of that plant and accrued business interest from the plant is mentioned in ALI’s financial statement even after the plan ceases to exist. Hence, the evidence of loss due to fire in one of the leased plant of ALI may go undetected and can have an adverse effect while interpreting the financial statements of ALI. c. The overall increase in sales volume and gross profit of ALI can lead to material misstatement because the sales revenue of ALI from Bombardier has not shown such increasing trend. Hence it is also a case of inherent risk where it is susceptible to material misstatement. 2. Control Risk: It is the risk of occurrence of any misstatements of certain transactions which can prove to be material in the financial statements. It can also be present either individually or in aggregated form with other types of transactions. The internal control system of an organization is unable to either prevent or detect such misstatements. ALI has also certain control risks associated with it. They can be summed up as follows: a. Control risk is prevalent in ALI with it not having a proper control system to record its substantial interest on GlueCo. Hence, there is a risk of the financial statements of ALI being materially misstated if it encounters a share of loss from GlueCo. b. ALI is going for a change by involving Exostar to process all the transactions related to bid submissions and sales with its three major newly acquired clients. This calls for a control risk because the control system of ALI may not be efficient in controlling the activities performed by Exostar on their behalf. Exostar’s accounting system may be faulty and can go undetected in the ALL’s financial statements, hence leading to control risk. c. There is also an evidence of control risk where ALI looks to mention $5.5 million as receivables in the financial statement as the amount being due as claim from the insurer, but the insurer has confirmed a claim amount less than this figure. Hence, the internal control system of ALI may not be able to detect such material misstatement. References Bell, Timonthy B. Auditing organizations through a strategic-systems lens - the KPMG Business Measurement Process. 1997, PDF file. 30 Mar 2012. . Colbert, Janet L., Michael S. Luehfling, and C. Wayne Alderman. “Auditing – Engagement Risk.” The CPA Journal (n.d.): n. pag. Web. 30 Mar 2012. . Financial Reporting & Assurance Standards Canada. “Enhancing Professional Skepticism.” Auditing and Assurance Bulletin. (Feb 2012): 2. PDF File. 30 Mar 2012. . Financial Reporting & Assurance Standards Canada. “Auditing Considerations in an Uncertain Economic Environment.” Auditing and Assurance Bulletin. (Mar 2012): 1-8. PDF file. 30 Mar 2012. . Fragniere, Emmanuel, and George Sullivan. Risk Management: Safeguarding Company Assets. MA: George Sullivan, 2006. Print. Rittenberg, Larry, E, et al. Auditing: A Business Risk Approach. 7th ed. USA: Cengage Learning, 2009. Print. Turley, Stuart. Current Issues in Auditing. Ed. Michael Sherer and Stuart Turley. 3rd ed. London: SAGE, 1997. Print. Read More