Auditing Theory and Practice: Inherent Risks and Materiality Assessment

This article discusses inherent risks and materiality assessment in auditing theory and practice. It covers the importance of audit risk assessment and preliminary materiality assessment in the audit process. The article also provides examples of inherent risks and the necessary factors to consider for preliminary materiality assessment.

Running head: AUDITING THEORY AND PRACTICE
Auditing Theory and Practice
Name of the Student
Name of the University
Author’s Note

1AUDITING THEORY AND PRACTICE
Table of Contents
Answer to Question 1......................................................................................................................2
Requirement A.............................................................................................................................2
Requirement B.............................................................................................................................3
Answer to Question 2......................................................................................................................5
Requirement A.............................................................................................................................5
Requirement B.............................................................................................................................6
References........................................................................................................................................8

2AUDITING THEORY AND PRACTICE
Answer to Question 1
Requirement A
Assessment of audit risk is an important step in audit profession. The auditors express
audit risk as wrong opinion on the analysis of the financial statements of the companies. Three
types of audit risks can be seen; they are Inherent Risk, Control Risk and Detection Risk.
Inherent risk considers as the risk of material misstatements of the financial statements caused by
errors and omission due to the internal control failure (Coetzee & Lubbe, 2014). Business entities
having complex business operations have higher inherent risks and internal control cannot
protect or detect inherent risks. All these aspects of inherent risk are applicable for MaxSecurity
Limited (MaxSecurity).
There are some major inherent risks in the business operations of MaxSecurity. The
complex nature of the manufacturing costing process of MaxSecurity indicates towards the
presence of inherent risks. In MaxSecurity, the presence of a complex manufacturing costing
procedure can be seen for the manufacturing of high-tech armor-plated personnel carriers. This
highly complex manufacturing process of MaxSecurity creates scope for errors as costing values
can be omitted in the process. These errors can affect the financial statements of the company
that can lead to the material misstatements in the financial statements (Ruhnke & Schmidt,
2014).
Apart from the above area, the presence of old costing system creates inherent risk in the
business operation of MaxSecurity. From the earlier discussion, it can be observed that
MaxSecurity uses a complex production process of high-tech armor-plated personnel carriers.
For this reason, the company requires an accurate advanced costing system in order to support

3AUDITING THEORY AND PRACTICE
the complex manufacturing procedure. In MaxSecurity, as the old costing system is in the
operation for manufacturing process, the company has to face the major risk of the omission of
the crucial costing related information as the system does not have the capability to develop a
database for gathering all the information of the manufacturing process (Jha & Chen, 2014).
Apart from this, the system has not the ability for the integration of cost information with the
balances of general ledger. All these aspects lead to material missstements in the financial
statements.
MaxSecurity operates in a highly competitive business environment and this particular
aspect is the potential of inherent risk in the audit operation. Thus, this risk can be considered as
the industry risk of the company. The occurrence of this risk can be seen due to the presence of
extreme pressure of the industry on the business operations of MaxSecurity (Griffiths, 2016). It
needs to be mentioned that it is not possible for effective internal control to diminish this risk.
These are the inherent risks of MaxSecurity.
Requirement B
It is required for the auditors to do the planning of every step of the audit operations. In
this process, it is needed for the auditors to take into consideration all the necessary factors of
material misstatements. With the assistance of materiality assessment, the auditors become able
to select the required audit procedures in order to reduce the audit risk in acceptable level
(William Jr, Glover & Prawitt, 2016). For this reason, the auditors are needed to take up the
procedures of preliminary materiality assessment for the determination of materiality level. The
following discussion shows the necessary aspects required to consider by the auditors for the
preliminary materiality assessment of MaxSecurity:

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It is required for the auditors to measure the reliability of provided information by the
management of MaxSecurity as this information assists in the audit process. It is the obligation
of the management of MaxSecurity to deliver the auditors different information about crucial
aspects; like basis of preparation of the financial statements, complied accounting standards and
others. For this reason, the auditors are needed to take up the testing of internal control for the
verification of the management’s information (Eilifsen & Messier Jr, 2014).
In the next process, it is necessary for the auditors of MaxSecurity to consider the crucial
aspects indicating the deviation in the normal business operations of MaxSecurity. As per the
provided information, the production of high-tech armour-plated personnel carriers is the main
business operation of MaxSecurity. For this reason, the main part of the revenue of MaxSecurity
should come from the sale of these carriers. However, the auditors of MaxSecurity has
encountered with the fact that the company has eared large amount of revenue from other
business operations apart from the sale of plates (Mio, 2013). Thus, it is the obligation of the
auditors to review this deviation from the actual operations.
At the same time, the auditors are needed to consider the qualitative factors of financial
reporting while assessing the preliminary materiality as the auditors use the level of material
misstatements in the preliminary assessment of materiality. Thus, the auditors are needed to
consider the five qualitative factors of financial statements. First, the auditors are needed to take
into consideration the inadequate description of accounting standards and policies as it can
mislead the users (Eilifsen & Messier Jr, 2014). Second, all the factors affecting the integrity of
financial reporting needs to be considered. Third, it is needed for the auditors of MaxSecurity
test the internal control in order to find the weaknesses in it as it can cause major material
misstatements in the financial reporting of MaxSecurity. At the same time, it is needed for the

5AUDITING THEORY AND PRACTICE
auditors of MaxSecurity to test the overall accounting and financial accounting process of
MaxSecurity. Hence, these are all the aspects required to be taken into consideration for
preliminary material missstements (William Jr, Glover & Prawitt, 2016).
Answer to Question 2
Requirement A
The confirmation of debtors provides a detailed documented report about the presence of
accounts receivable in the accounting operations of Medical Services Holdings Group (MSHG).
In the presence of positive replies from the debtors, the auditors obtain external evidence related
to accounts receivable. Moreover, the evidence about the rights and obligations related to debtors
can be obtained from the process of debtor confirmation. It provides evidence on the fact that
whether MSHG actually owes the amount from the debtors or not. It is not possible for the
entities to obtain reliable evidence about the allocation and valuation of the debtors because the
debtors do not provide the assurance to pay their dues to the entities (Leung et al., 2014).
As per the provided information, the trade receivable balance was $3974569 and it is a
material balance. The payment terms for the large part of the debtors are 14 days and the small
debtors are due for 60 days. From this fact, it can be seen that there is ineffectiveness in the
process of credit approval and the collection of outstanding amounts from the debtors. It needs to
be mentioned that the auditors can obtain correct evidence about the existence of the debtors as 5
medical practitioners owe 60% of the total debtors. In spite of this, the auditors are needed to
conduct further audit procedures for obtaining reliable proof related to the valuation of the
debtors (Knechel & Salterio, 2016).

6AUDITING THEORY AND PRACTICE
In addition to the big debtors accounts, the presence of small accounts of debtors can be
seen in the company that consists of 40% of the total debtors. It can be observed that there are
major issues with these small balances of debtors as the allowance period of 14 days has already
been crossed for the collection of these balances. The debtor confirmation process assists the
auditors in obtaining correct evidences in order to ensure their evidence, but there is a need for
other processes in order to do valuation of the balances of these accounts (Duncan &
Whittington, 2014). The provided case states that there is a direct consideration of the allowance
of doubtful debts against the trade receivable accounts. This particular aspect demands a
transaction test from the auditors. In addition, the auditors are also required to run a check for
finding the reasons for ineffective credit control. In the presence of all these aspects, it is the
additional responsibility of the auditors to review the receipts of the debtors. After that, the
auditors are also needed to conduct analysis on the characteristics of the debtors account in order
to obtain proper evidence for the correct valuation of the debtors of Shady Oakes (Knechel &
Salterio, 2016).
Requirement B
As per the provided case study, it can be seen that the auditors of Chan and Partners is
not going to use debtor confirmation results as the only evidence of audit. The main reason is
that it is not possible for the auditors to obtain sufficient evidence from debtor confirmation
about the allocation and valuation of the debtors. Another two major reasons for not selecting
debtor conformation as only audit evidence are the presence of materiality in debtor balance and
the fact the smaller debtor balance is due (Christensen, Glover & Wood, 2013).
In this particular case, the requirement of the auditors is the review and testing of data,
assumption and methods adopted by the management of Shady Oakes in order to obtain the

7AUDITING THEORY AND PRACTICE
reasonable assurance about the accenting treatment of debtors. At the same time, the auditors are
required to make discussion with the management of the company for understating their adopted
procedures and approaches for the recognition of doubtful debt. Thus, for the auditors, the
requirement is to take up further audit procedures in order to ascertain the value and allocation of
debtor balances (Chambers & Odar, 2015). Thus, certain additional procedures are required to be
taken up by the auditors like analysis of the receipts of the debtors and invoice for verifying the
debtors balances.
The relevance of this case can be seen with the Auditing Standard ASA 230 Audit
Documentation. The objective of this audit standard lies in the examination of timing, nature and
extent of needed audit techniques in order to classify and value the debtor account balances in
business entities. In the presence of this audit standard, the identification of all the crucial
matters related to the debtor account needs to be done by the auditors (Shah & Nair, 2013). After
that, compliance with all the required audit standards is needed by the auditors. Moreover, the
auditors must review all the related information about debtor balance for Shady Oakes. Lastly,
the auditors need to write all these test results in a document.
Hence, based on the above discussion, it can be seen that the auditors of Chan and
Partners will not be able to use debtor conformation as the only evidence for the audit operation
of Shady Oakes. The existence of internal weakness in the collection of due amount from the
debtors can be considered as the major reason for this. Thus, the auditors are required to ensure
the correct collection of dues from the debtors. It will helps in bringing transparency in the whole
process of debtor collection (Minuti‐Meza, 2013).

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References
Chambers, A. D., & Odar, M. (2015). A new vision for internal audit. Managerial Auditing
Journal, 30(1), 34-55.
Christensen, B. E., Glover, S. M., & Wood, D. A. (2013). Extreme estimation uncertainty and
audit assurance. Current Issues in Auditing, 7(1), P36-P42.
Coetzee, P., & Lubbe, D. (2014). Improving the efficiency and effectiveness of risk‐based
internal audit engagements. International Journal of Auditing, 18(2), 115-125.
Duncan, B., & Whittington, M. (2014, September). Compliance with standards, assurance and
audit: does this equal security?. In Proceedings of the 7th International Conference on
Security of Information and Networks (p. 77). ACM.
Eilifsen, A., & Messier Jr, W. F. (2014). Materiality guidance of the major public accounting
firms. Auditing: A Journal of Practice & Theory, 34(2), 3-26.
Griffiths, P. (2016). Risk-based auditing. Routledge.
Jha, A., & Chen, Y. (2014). Audit fees and social capital. The Accounting Review, 90(2), 611-
639.
Knechel, W. R., & Salterio, S. E. (2016). Auditing: Assurance and risk. Taylor & Francis.
Leung, P., Coram, P., Cooper, B. J., & Richardson, P. (2014). Modern Auditing and Assurance
Services 6e. Wiley.

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MINUTTI‐MEZA, M. I. G. U. E. L. (2013). Does auditor industry specialization improve audit
quality?. Journal of Accounting Research, 51(4), 779-817.
Mio, C. (2013). Materiality and assurance: building the link. In Integrated Reporting (pp. 79-94).
Springer, Cham.
Ruhnke, K., & Schmidt, M. (2014). Misstatements in financial statements: The relationship
between inherent and control risk factors and audit adjustments. Auditing: A Journal of
Practice & Theory, 33(4), 247-269.
Shah, M., & Nair, C. S. (Eds.). (2013). External Quality Audit: Has it Improved Quality
Assurance in Universities?. Elsevier.
William Jr, M., Glover, S., & Prawitt, D. (2016). Auditing and assurance services: A systematic
approach. McGraw-Hill Education.