Auditing Risk: Key Areas and Substantive Procedures
This paper examines the concept of audit risk and its three components—inherent risk, control risk, and detection risk—before identifying areas of heightened audit risk in the financial statements of Havelock Europa PLC. The paper focuses on three key risk areas: revenue recognition, taxation, and profit reporting, explaining how each may be subject to material misstatement or fraud. In the second part, the paper presents five substantive audit procedures specifically designed to address revenue-related risks, detailing how each procedure helps reduce audit risk to an acceptably low level. The analysis draws on the company's 2013 Annual Report alongside established auditing and anti-fraud literature.
- Introduction to Audit Risk: Defines audit risk formula and its three components
- Revenue as a High-Risk Area: Revenue recognition fraud risks in Havelock Europa
- Tax as a High-Risk Area: Corporation tax rate misapplication and deferred tax risks
- Profit Misstatement Risks: Profit inflation or understatement to mislead stakeholders
- Substantive Audit Procedures for Revenue: Five targeted procedures to reduce revenue audit risk
- Conclusion: References supporting the audit risk analysis
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What makes this paper effective
- Clearly applies the audit risk formula (Inherent Risk × Control Risk × Detection Risk) as a framework, grounding the discussion in established auditing theory before moving to company-specific analysis.
- Uses specific numerical examples from Havelock Europa's 2013 Annual Report—such as deferred tax asset calculations at different tax rates—to illustrate abstract risk concepts concretely.
- Maintains a logical two-part structure: first identifying risk areas, then proposing targeted substantive procedures that directly respond to each identified risk.
Key academic technique demonstrated
The paper demonstrates applied risk analysis by linking theoretical audit risk components to specific line items in a real company's financial statements. Rather than discussing fraud risk in the abstract, it traces how particular misstatement schemes—such as premature revenue recognition or incorrect tax rate application—could manifest in Havelock Europa's accounts, and then prescribes audit procedures that directly address each mechanism.
Structure breakdown
The paper opens with a definition of the audit risk model, then devotes a section each to three high-risk financial statement areas (revenue, tax, and profit). Part B shifts to practice, presenting five numbered substantive procedures for the revenue area, each accompanied by a rationale explaining what specific risk it mitigates. References follow in a consistent citation format.
Introduction to Audit Risk
Audit risk is expressed by the formula: Audit Risk = Inherent Risk × Control Risk × Detection Risk. Audit risk can be defined as the probability that an audit team will issue an unqualified judgment when the financial statements of an institution are in fact materially misstated. Inherent risk is the possibility that material frauds and errors will enter the accounting system used to prepare the financial statements. Control risk, on the other hand, is the possibility that a client's or company's internal control system is unable to prevent or detect material misstatements (Griffiths, 2005). Finally, detection risk is the probability that an auditor's procedures will fail to detect material misstatements. Taking into consideration the financial statements and management commentary in the annual report of Havelock Europa PLC, there are several areas of heightened audit risk concerning the audit of the company.
One major area of risk in the financial statements of Havelock Europa is improper revenue recognition. In particular, key audit risks concerning revenues include fraud or material misstatements arising from revenue recognition and the timing of revenues. It is important to note that numerous fraudulent schemes have been employed across different organizations to misstate the amount and level of revenues.
Revenue as a High-Risk Area
One major aspect to consider in the financial statements of this company is the possibility of sham sales. Company representatives and agents might falsify inventory records, shipping records, and invoices, and record fictitious transactions as sales revenue. This risk is heightened by the fact that, as the management notes in the company's annual report, while the production facility is located in Scotland, a substantial portion of the company's revenue is generated in the rest of the United Kingdom and the European Union (Havelock Europa PLC, 2013). In certain situations, the company might ship its goods to a different location; in others, company representatives might pretend to ship inventory and conceal this information from auditors.
Another probable risk is the premature recognition of revenues before all terms of a sale have been completed. Representatives could record sales for products or goods that have been ordered even before they are shipped to the customer, or before all risks have been transferred to the customer. A further area of risk regarding revenues is that accounting records may be held open past the balance sheet date so that sales occurring in the following period are recorded in the current period (Goldman and Kaufman, 2011).
Another area of the financial statements carrying high audit risk is taxation. Material misstatements and omissions regarding tax are typically made with the intent of avoiding taxes or paying less than is legally required. This type of fraud can take many different forms, ranging from improper categorization of expenditure to reduce taxable income, to misstatements of income and the improper classification of executive reimbursements (Goldman and Kaufman, 2011).
For Havelock Europa, this is an area of considerable risk. The company has not paid any corporation tax on profits generated during the year due to losses brought forward. This represents a risk because the company could easily declare greater losses or reduce the level of taxable income in order to pay less tax. The company recognizes that current tax is the taxation charge payable on taxable income for the reporting period, calculated using tax rates enacted or substantively enacted at the balance sheet date, together with any adjustment to tax payable in respect of previous years.
It is important to note that the UK corporation tax rate changed during the reporting period, declining from 24% to 23% in 2013, then further to 21% in 2014, and to 20% in 2015 (Havelock Europa PLC, 2013). Because the reduction to 20% was enacted before the balance sheet date, deferred tax assets and liabilities must be recognized at the 20% rate. This decline in the corporation tax rate means that losses carried forward and recognized on the balance sheet as deferred tax assets have a lower value. This creates an audit risk: the company might choose to recognize deferred tax assets and liabilities at 21% rather than 20% in order to report a higher deferred tax asset value on the balance sheet (Havelock Europa PLC, 2013).
Tax as a High-Risk Area
For example, in the balance sheet as of 31 December 2013, the deferred tax assets recognized for the group were £1,167 and £2,315 for the years 2012 and 2013 respectively. The risk is that the company could have applied the 24% rate rather than 23%, which would have resulted in higher reported deferred tax assets (Havelock Europa PLC, 2013):
1.24/1.23 × 1,167 = 1,176 and 1.24/1.23 × 2,315 = 2,334
Recognizing assets at the higher rate would provide the company with greater apparent tax relief and would constitute fraud or a material misstatement (Havelock Europa PLC, 2013).
Profit is an area of high risk because it can be materially misstated for two contrasting reasons. First, the company may choose to inflate its profit level in order to appear more profitable and successful to investors and stakeholders, causing the preparers of financial statements to overstate the amount of profit. Conversely, the company might also report profit levels that are lower than those actually generated in order to avoid paying the taxes required by the government. By reporting losses rather than profits, the company avoids tax liability — a practice that constitutes a significant fraud risk (Goldman and Kaufman, 2011).
Of the three risk areas discussed above, revenue is selected for further analysis. The following five substantive audit procedures would be carried out in an attempt to reduce audit risk to an acceptably low level.
Conclusion
Rittenberg, L., Johnstone, K., & Gramling, A. (2012). Auditing: A Business Risk Approach. USA: South Western Cengage.
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