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Risk of Material Misstatement

Updated on April 28, 2015

Accounting Problem:

Your client, a manufacturer of computer components, has experienced slowing demand for its product. Recently, it cut back from three shifts a day to two shifts a day, and the company has eliminated the backlog of orders that existed in prior years by providing financing to customers. Newspaper reports indicate that competition has taken significant business away from the client because a large investment in R&D has not resulted in improved products. Furthermore, a small handful of your client’s customers are experiencing financial difficulties because of slowing demand for your client’s products.


Consider the implications of the above information for revenues. What assertions, if any, are likely to be misstated? As a result, what accounts are likely to be overstated or understated? Explain your reasoning.

With fewer orders and sales, a closer look at receivable turnover rate should be considered and compared with prior year’s figures. If it appears that the inventory is not turning over as quickly as it should be, a larger reserve for receivables may be needed.

In addition, sales orders should be inspected to ensure that items that were ordered, were actually shipped. If production is down, receivables may have been booked but not shipped, so shipping logs should be compared with sales orders.

Consider the implications of the above information for inventory. What assertions, if any, are likely to be misstated? As a result, what accounts are likely to be overstated or understated? Explain your reasoning.

It is likely that income will be overstated. A closer look at inventory levels, including a physical count of inventory and a comparison of inventory and shipping logs. Sales should not be booked if inventory has not been shipped.

Problems may also arise with purchases that haven’t been booked. Following the paper trail should aid in preventing this factor.

In addition, it is necessary to make sure that there are no intangible assets relating to R&D remaining on the balance sheet. If so, R&D items should be written off as expenses.

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.

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.

Identify the relevant assertion. - Good internal control.

Does this assertion represent a significant inherent risk? - Yes. Significant because without strong internal controls, how can financial statements be relied upon?

How might you respond to this risk in terms of staffing decisions? - Test of internal controls and based upon findings, collaborate the general consensus of strong controls. If this can be collaborated than auditing testing and sampling can be reduced. However, if a control weakness is detected you have to expand the testing and sampling of the accounts.

How might you respond to this risk in terms of the nature of audit tests? - Good internal controls can eliminate the amount of testing of the internal control procedures. If weaknesses are detected, an expansion of testing and sampling will be needed.

How might you respond to this risk in terms of the timing of audit tests? - The majority of time should be spent on testing of internal controls, if preliminary testing shows control deficiencies. If severe deficiencies exist, year-end audit procedures should be modified.

How might you respond to this risk in terms of the extent of audit tests? - If internal controls are strong, fewer tests are required, it internal controls are weak an expansion of control testing is needed.

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.

Identify the relevant assertion. - Television industry is very competitive with declining prices falling over time.

Does this assertion represent a significant inherent risk? - No. Although the marketplace is constantly changing, with this in mind, audit tests and procedures must be modified, these are factors to be considered.

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.

Identify the relevant assertion. - Purchase of Micro Engineering resulted in allocation of specific assets of 65% and purchase price of 35% intangibles (goodwill).

Does this assertion represent a significant inherent risk? - No. There is not much inherent risk with Micro Engineering, because the company was valuated by an outside company.

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