Read the business characteristics indicative of high inherent risk on page 145* of your text and think of a company that you would consider to be a risky audit. Go to the company's website and review their annual report and/or 10-K and read Management's Discussion and Analysis. What information concerning risk is in this discussion and what would the auditor need to consider in determining the audit risk and controlling it? Your answer must be in your own words. Approximate length: 1 to 2 double-spaced pages.

*page 145

Financial statement assertions are important to auditors because they should consider audit risk at the assertion level for all significant account balances, transaction classes, and disclosures. Audit risk consists of (1) the risk of material misstatement of a relevant assertion related to an account balance, class of transaction, or disclosure and (2) the risk that the auditors will not detect such misstatement. The Risk of Material Misstatement (Inherent Risk and Control Risk) The risk of material misstatement may be separated into two componentsinherent risk and control risk. Inherent risk is the possibility of material misstatement of an assertion before considering the clients internal control. Factors that affect inherent risk relate to either the nature of the client and its environment or the nature of the particular financial statement element. Business characteristics of the client and its environment affect the inherent risk of the audit as a whole. Therefore, these characteristics affect the assertions about a number of financial statement accounts. For example, business characteristics such as the following are indicative of high inherent risk:

Inconsistent profitability of the client relative to other firms in the industry.

Operating results that are highly sensitive to economic factors.

Going concern problems.

Large known and likely misstatements detected in prior audits.

Substantial turnover, questionable reputation, or inadequate accounting skills of management.

Since these factors increase the overall risk of the audit, they are important to the auditors decisions about whether to accept the engagement. Inherent risk also varies by the nature of the account. Assume that in a given business the balance of the Inventory account amounts to only one-fifth that of the Property and Equipment account. Does this relationship indicate that the auditors should spend only one-fifth as much time in the audit of inventory as in the audit of plant and equipment? The answer to this question is no. Inventory is much more susceptible to error or theft than are plant and equipment, and the great number of inventory transactions affords an opportunity for misstatements to be well hidden. Inherent risk also varies by the assertion about a particular account. As an example, valuation of assets is often a more difficult assertion to audit than is existence of the assets. In general, assertions with high inherent risk involve:

Difficult-to-audit transactions or balances.

Complex calculations.

Difficult accounting issues.

Significant judgment by management.

Valuations that vary significantly based on economic factors.

In assessing inherent risk, it is often useful to segregate transactions into three typesroutine, nonroutine, and estimation. Routine transactions involve recurring financial statement activities recorded in the accounting records in the normal course of business. Examples of routine transactions are sales, purchases, cash disbursements, cash receipts, and payroll transactions. The routine nature of these transactions restricts inherent risk, although controls certainly must be implemented to assure proper recording.