Q1- Bon Garage

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Interactive case study Bon Garage Bhd Your firm has recently been appointed as external auditor of Bon
Garage Bhd (Bon Garage), a listed company, following the resignation of the previous auditor. Bon
Garage is a retailer of a range of new and used cars from sites in major Malaysian cities.

To secure the sale of a new car, Bon Garage frequently takes a customer’s used car in part exchange. The
used car is then sold to another customer or is sent to an auction to be sold. This is your firm’s first listed
company client and its only client in the motor trade industry.

During the audit of the financial statements for the year ended 30 June 2022, the following was
discovered:

(a) On a number of occasions, the company’s sales manager, helped by the accounts clerk, has
deliberately falsified details of the value of vehicles sold in order to increase his monthly bonus
payments.

(b) On a number of occasions, sales staff granted customer discounts in excess of authorised levels.

(c) Bon Garage publicly claims that each used car is assessed against a checklist of 100 items to ensure
that it is safe to drive. Workshop managers have stated that, because of insufficient time, some of these
checks are rarely performed.

The draft financial statements for the year ended 30 June 2022 show profit before tax of RM22.9 million
and total assets of RM121 million.

Requirements

1. Explain why the risk of expressing an inappropriate opinion may be higher in your firm’s first audit of
Bon Garage’s financial statements. Outline how your firm can mitigate this risk.

(8 marks)

The auditor obtains and evaluates audit evidence to obtain reasonable assurance about whether the
financial statements give a true and fair view (or are presented fairly, in all material respects) in
accordance with the applicable financial reporting framework. The concept of reasonable assurance
acknowledges that there is a risk the audit opinion is inappropriate. The auditor should look to the
requirements of the Securities and Exchange Commission for the company under audit with respect to
the accounting principles applicable to that company. The risk that the auditor expresses an inappropriate
audit opinion when the financial statements are materially misstated is known as “audit risk”. Audit risk
is a function of two main components, being the risk of material misstatement and detection risk. Risk of
material misstatement is made up of a further two components, inherent risk and control risk.

Component of risks

Inherent risk is the susceptibility of an assertion about a class of transaction, account balance or
disclosure to a misstatement which could be material, either individually or when aggregated with other
misstatements, before consideration of any related controls.

Control risk is the risk that a misstatement which could occur in an assertion about a class of
transaction, account balance or disclosure and which 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.

Detection risk is the risk that the procedures performed by the auditor to reduce audit risk to an
acceptably low level will not detect a misstatement which exists and which could be material, either
individually or when aggregated with other misstatements. Detection risk is affected by sampling and
non-sampling risk.

Issues Audit Risk Mitigate Risk

Risk of material misstatement

which is control risk
In the case of Bon Garage, the
sale manager doing on purpose to In the event that management insists on
deliberately falsified details of the financial statement disclosure that the auditor
a) value of vehicles sold in order to finds unacceptable, the auditor can either
increases his monthly bonus issue an adverse or qualified opinion or
payment. That will charge under withdraw from the engagement.
risk of misstatement which is
control risk that occur by fraud
that aggregated with other
misstatement.

Risk of material misstatement

which is inherent risk
In the case of Bon Garage, the
sales staff granted discount to
customer which is could lead to
fraud when involve transaction of
amount that could be material for Confirm discounts applied to invoices agree
b) financial statement that to the customer master file.
aggregated with other
misstatement and consider of the
 discount that been set by
company.

Detection risk
The manager of Bon Garage has
not follow the procedure of Conduct additional substantive test, as well
c) checklist because insufficient time as by assigning the most experienced staff to
might lead to material when they an audit.
cannot detect misstatement which
could be exist. The checklist
procedure acts as sampling risk.

Audit risk

In an audit of financial statements, audit risk is the risk that the auditor expresses an inappropriate audit
opinion when the financial statements are materially misstated. For example, the financial statements
are not presented fairly in conformity with the applicable financial reporting framework. Audit risk is a
function of the risk of material misstatement and detection risk. The auditor should look to the
requirements of the Securities and Exchange Commission for the company under audit with respect to
the accounting principles applicable to that company.

Risk of material misstatement

The risk of material misstatement refers to the risk that the financial statements are materially misstated.
Auditing Standard No. 12, Identifying and Assessing Risks of Material Misstatement, indicates that the
auditor should assess the risks of material misstatement at two levels: (1) at the financial statement
level and (2) at the assertion4/ level.5/

Risks of material misstatement at the financial statement level relate pervasively to the financial
statements as a whole and potentially affect many assertions. Risks of material misstatement at the
financial statement level may be especially relevant to the auditor's consideration of the risk of material
misstatement due to fraud. For example, an ineffective control environment, a lack of sufficient capital to
continue operations, and declining conditions affecting the company's industry might create pressures
or opportunities for management to manipulate the financial statements, leading to higher risk of
material misstatement.

Risk of material misstatement at the assertion level consists of the following components:

1. Inherent risk, which refers to the susceptibility of an assertion to a misstatement, due

to error or fraud, that could be material, individually or in combination with other
misstatements, before consideration of any related controls.

2. Control risk, which is the risk that a misstatement due to error or fraud that could occur
in an assertion and that could be material, individually or in combination with other
 misstatements, will not be prevented or detected on a timely basis by the company's
internal control. Control risk is a function of the effectiveness of the design and operation
of internal control.

Inherent risk and control risk are related to the company, its environment, and its internal control, and
the auditor assesses those risks based on evidence he or she obtains. The auditor assesses inherent
risk using information obtained from performing risk assessment procedures and considering the
characteristics of the accounts and disclosures in the financial statements.6/ The auditor assesses
control risk using evidence obtained from tests of controls (if the auditor plans to rely on those controls
to assess control risk at less than maximum) and from other sources.7/

Detection Risk

In an audit of financial statements, detection risk is the risk that the procedures performed by the auditor
will not detect a misstatement that exists and that could be material, individually or in combination with
other misstatements. Detection risk is affected by (1) the effectiveness of the substantive procedures
and (2) their application by the auditor, i.e., whether the procedures were performed with due
professional care.

The auditor uses the assessed risk of material misstatement to determine the appropriate level of
detection risk for a financial statement assertion. The higher the risk of material misstatement, the lower
the level of detection risk needs to be in order to reduce audit risk to an appropriately low level.

The auditor reduces the level of detection risk through the nature, timing, and extent of the substantive
procedures performed. As the appropriate level of detection risk decreases, the evidence from
substantive procedures that the auditor should obtain increases.8/

Step

1/ When the auditor is performing an integrated audit of financial statements and internal control over
financial reporting, the requirements in Auditing Standard No. 5, An Audit of Internal Control Over
Financial Reporting That Is Integrated with An Audit of Financial Statements, also apply. However, the
risks of material misstatement of the financial statements are the same for both the audit of financial
statements and the audit of internal control over financial reporting.

2/ Misstatement is defined in Appendix A of Auditing Standard No. 14, Evaluating Audit Results.

3/ See AU sec. 110, Responsibilities and Functions of the Independent Auditor, and paragraph .10 of
AU sec. 230, Due Professional Care in the Performance of Work, for a further discussion of reasonable
assurance.

4/ See Auditing Standard No. 15, Audit Evidence, for a description of financial statement assertions.

5/ Paragraph 59 of Auditing Standard No. 12.

6/ Paragraph 59.a. of Auditing Standard No. 12.

7/ Paragraphs 32-34 of Auditing Standard No. 13, The Auditor's Responses to the Risks of Material
Misstatement.

8/ Paragraph 37 of Auditing Standard No. 13.