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Developing responses to assessed risks in terms of testing

Developing responses to assessed risks

Your client, General Television, Inc. manufactures televisions and during the current year acquired Micro Engineering, Inc., which manufactured flat panel plasma screens for computers so that it could compete in the market for flat panel televisions. Following is a list of several risks that have been identified in the audit of this television manufacturer.

1. General Television has strong internal controls over the existence of inventory. It has a good perpetual inventory system and regularly compares inventory on hand with the perpetual records.

2. Prices have been changing rapidly in General Television's marketplace. Although the marketplace is relatively stable for traditional televisions, the prices on flat panel televisions have become much more competitive.

3. General Television had to pay a premium to acquire Micro Engineering. General Television had independent appraisals of the fair value of assets and has determined that about 35 percent of the purchase price should be allocated to goodwill.


Answer the following questions for the risks described in 1, 2, and 3 above.

a. Identify the relevant assertion.
b. Does this assertion represent a significant inherent risk? Explain.
c. How might you respond to this risk in terms of staffing decisions?
d. How might you respond to this risk in terms of the nature of audit tests?
e. How might you respond to this risk in terms of the timing of audit tests?
f. How might you respond to this risk in terms of the extent of audit tests?

Solution Preview

a. The relevant assertion is existence or occurrence.

b. An inherent risk recognizes that an error is more likely to occur in some areas than in others. In this case, the total value of inventory in a volatile market (with respect to pricing) is clearly one where inventory might easily be overstated, whether intentional or not. When inventory is overstated, cost of goods is understated and therefore profit is overstated. Inventory may be the most important part of this audit.

c. For an important part of the audit where errors are more likely to occur, it would be wise to put more highly trained staff on this part of the engagement. Closer supervision of staff is also warranted.

d. Considering the inherent risk, it would be wise to extend the testing of the system of internal controls. The type of tests performed for the assertion of existence and occurrence is the test of transactions and account balances. These two procedures are essentially the methods to prove that the system of internal controls is functioning properly.

e. Inventory tests of transactions often occur before year end, or can partly occur before year end. Having tested some transactions will assist with the design of the audit program to ensure that adequate testing will be completed. Testing account balances must be after year end. With physical inventory that can move in and out quickly, the inventory testing should be one of the first areas that an audit teams works in.

f. The extent of the tests will be determined by the ...

Solution Summary

In a 1,049 word discussion, the relevant assertions are discussed in detail as they apply to each part of the problem.