AA - Revision

Dec 2008 Q4 - EUKARE

SOLUTION:

a)

An audit risk is the risk that the auditor will give an inappropriate opinion on the financial statements. For
example, there could be material misstatements in the financial statements and the auditor has stated the
accounts are true and fair. Auditors need to calculate this at the planning stage.

Auditors have an audit risk model that they use to consider all risks associated with the audit. The model breaks
audit risk into 3 components and is presented as:

AR = IR x CR x DR

IR stands for inherent risk. Inherent risk is the risk that the auditor will give an inappropriate opinion due to the
nature of the client. What we mean by nature of the client is basically what the company does and how it is
structured. These inherent risks could also relate to the industry there are in. There is very little that can be done
to reduce inherent risks.

CR stands for control risk. Control risk is the risk of the auditor giving an inappropriate opinion due to the
client’s poor controls and systems. If the client has weak internal controls, there is a greater risk of
misstatements being present in the financial statements, which the auditor has to find. Little can be done in the
current year regarding control risk, but remember recommendations can be made to improve systems and
controls in the future

DR is detection risk. Detection risk is the risk of giving an inappropriate opinion due to the auditor not spotting a
material misstatement. The more problems a client has, the greater the risk of the auditor not finding all material
misstatements. The key is to assess inherent and control risk first. If it is a high-risk client then detection risk
must be low. The only way to reduce detection risk is to increase the time spent, skills and sample sizes during
the audit.
b)
Area of Inherent risk
- They rely wholly on voluntary donations. There
is a risk that income would fall during times of
economic decline which could affect disclosure
requirements in the financial statements.
Disclosure on going concern may be
inappropriate for the charity.
- There is a detailed constitution which explains
how income can be spent. There is a risk that
income may be spent on items not within the
aims of the charity, and disclosure on this may
be incomplete.
- Administration expenses cannot exceed 10% of
income in any year. There is a risk that the
charity may cover up expenditure in excess of
10% by misallocating costs, causing
misstatements in balances.
- Cash is collected in shopping areas from
volunteers. There is a risk that some cash may
be stolen and donations are incomplete. This
would lead to incomplete income recorded in the
financial statements.
- Some individual donations have specific clauses
attached to them. This could be that amounts
are not allowed to be spent and other amounts
are to be spent on certain activities. There is a
risk that the charity does not follow these
instructions from the donor and this is not
disclosed in the financial statements.
- There are complicated tax rules for charities in
the country they are based. There is a risk that
the tax rules could be broken by calculating tax
incorrectly and not understanding the detail
properly. This causes a misstatement in the tax
balance in the financial statements and potential
fines.
c)
For auditors to assess the control environment as good, they are looking for evidence that the management
have a good attitude, awareness, and actions towards controls.
It is possible that the trustees may not have the focus or the knowledge to ensure controls are strong. There may
be an impression that controls are not important and this is likely to filter down to the people working and
volunteering for the charity.
Effect on the audit approach
In terms of audit approach, this makes it difficult to
assess their foreseeable future as it depends on
what others are likely to give to this and any other
charity. Going concern review would need to be
detailed and quite difficult to conclude.
The audit approach would be to ensure the
auditors understand the spending restrictions.
They should carefully review expenditure to
ensure it is suitable.
The auditors must review other accounts where
costs may have been misallocated to identify
possible misstatements.
Audit procedures to confirm completeness of
income are unlikely to be sufficient as it is
impossible for the auditor to follow all volunteers
around and record what is donated. Therefore this
would affect the opinion in the audit report as the
auditor may not be able to obtain sufficient
appropriate evidence to confirm that assertion.
The audit approach would be to review
documentation on individual donations and the
detailed spending requests and compare to the
actual expenditure made by the client. Any
discrepancies should be reported to management.
The audit team should include those experienced
and familiar with the tax rules so that careful
review of the tax calculations can be made.
Volunteers make up a proportion of the staff within the charity. These tend to be part-time and temporary and
therefore work handovers are regular, making the system unreliable and misstatements probable. It also means
explanations are difficult for the auditor to obtain as individuals are no longer available.

There would be a lack of segregation of duties. This would mainly be due to restricted resources available to the
charity. There is, therefore, a risk of misstatements as a review of work or even understanding responsibilities is
unlikely.

Due to the lack of organisational structure, it is unlikely to be an internal audit department. This lack of resource
means the charity will not be reviewing control systems for deficiencies and looking at ways to improve the way
they operate.