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 an extended audit to provide as much assurance as possible that you’ll detect those misstatements. Here are some prime examples of high-risk items:
The company has changed accounting principles. For example, it may have switched its method of valuing ending inventory from the last-in, first-out (LIFO) method to the first-in, first-out (FIFO) method.
What does that mean? A good example of FIFO is buying milk at the grocery store. The store pushes the old milk cartons in front so they’ll be sold by the expiration date. An example of LIFO would be anything sold out of a container. The items at the top will sell before the items at the bottom, which have been in the container longer.
Your initial assessment is that fraud may exist. One possible way to make this assertion is if you’ve determined internal controls are weak, which helps facilitate fraud because it’s easier to slip the fraudulent act through the cracks.
Another badge of potential fraud is if executive compensation appears to be reflected 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.
The company has an international presence that involves cross-border transactions. At the very least, you’ll be dealing 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’ll also be dealing with international financial records that may be in an unfamiliar setup 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.