How to Respond to a High-Risk Assessment
If an audit engagement is high-risk, you have to sit back, evaluate how the company does business, and think about how material misstatements may slip through the cracks. You then design a more extensive audit to provide as much assurance as possible that you’ll detect those misstatements.
The company changed an accounting principle
A change in accounting principle can distort the financial statements and cause confusion for the financial statement reader. Assume, for example, a company changes its method of valuing ending inventory from the first-in, first-out (FIFO) method to the last-in, first-out (LIFO) method.
Changing the method of valuing inventory distorts the cost of sales expense and, ultimately, net income. FIFO assumes you sell the oldest units first. Because inflation causes prices to rise, the older units are typically the cheapest units, so selling the least expensive goods first generates more net income sooner.
Keep in mind that total units sold and total cost of sales for all units is the same using either method. When you start selling those newer, more expensive units by using FIFO, you recognize more cost of sales and less income. If you apply FIFO and LIFO correctly, your revenue, cost of sales, and profit are the same by using either method, after all the units have been sold.
If you change the inventory valuation method in midstream, you can imagine how costs and profits are distorted. Specifically, the change in method may mean that you never apply the higher or lower costs to the units. In either case, the financials are distorted.
The financial impact of the change in accounting method must be disclosed. But even if it is disclosed, the change in method may be an attempt to manipulate the financial statements.
Suspecting fraud in your initial assessment
You may encounter warning signs of fraud when you conduct your initial assessment. If, during your initial assessment, you determine that a company’s internal controls are weak, you may need to dig deeper to find out why and identify any incidents of fraud. Weak internal controls facilitate fraud by making prevention and detection less likely.
Another red flag for potential fraud is the recording of executive compensation as a loan to the employee instead of an expense on the income statement. This situation reflects poorly on management integrity and also serves to artificially inflate net income.
Working with cross-border transactions
Consider a company that has an international presence that involves cross-border transactions. At the very least, you have to deal with currency conversions such as dollars (USD) to euros (EUR), which can be subjective.
For example, should certain accounts be valued at the year-end conversion rate, the conversion rate on the date of occurrence of the accounting event, or an average conversion rate representing fluctuations taking place all year? What’s the right answer? This is something evaluated company by company and is a topic for discussion with your audit supervisor.
You also may have to deal with international financial records that may be in an unfamiliar format or a language you can’t read or speak. The books may not be prepared in accordance with U.S. GAAP, which takes you out of your area of expertise.
Actions you take during a low-risk engagement are flip-flopped for a high-risk one. More experienced staff associates work on the engagement. The senior associates become more hands-on. Your firm may hire outside specialists who have knowledge and skills relating to the business’s specific needs that are lacking in the CPA firm.
Professional skepticism increases, as does the number of items selected for sampling. You may use more extensive analytical procedures, which compare the business’s financial data with your expectations of how the data should look. For example, if the industry standard is that the current ratio (current assets/current liabilities) is 2 percent, you rigorously question the client if its current ratio deviates from the norm.