You should recall that inherent risk is the susceptibility of an account balance or class of transactions to a material misstatement (remember that IR is defined and discussed in ASA 200.13(n), A36-A43). The account balances and transaction classes of interest to us here are accounts receivable, inventory, sales, and cash receipts (each of those accounts is impacted on by transactions recording credit sales and subsequent collection of the balance owing … remember your pre-requisite accounting knowledge).
A number of factors are considered in the assessment of inherent risk – the quantity & size of transactions that occur during the period, history of the company in this area, likelihood of theft, necessity to perform complicated calculations for reports, industry problems, need for estimations, results of analytical procedures and possibility of obsolescence. You will be aware that you have information on these from your work thus far – remember to apply the facts from Lakeside to the factors discussed in ASA 200 paragraphs noted above.
For e.g., inventory and accounts receivable would have a high inherent risk at Lakeside. There are numerous transactions in buying and selling inventory (retail stores and through the distributorship), computations of discount and freight may pose problems due to the terms and conditions of trading and returns, possibility of write-offs, theft, breakage and technological obsolescence is high, requiring estimations.
At Lakeside, IR and CR are both assessed at the high level, impacting on the assessment of detection risk and the resulting level of substantive testing. The high level of IR and CR means that there is high chance of material misstatements occurring and a high chance that the internal controls will not prevent, detect and correct those material misstatements. This means that we want to minimise our detection risk (set it to a low level) by careful and thorough substantive testing – minimising the chance that our tests will not detect those material misstatements! This means gathering relatively more evidence from our substantive testing procedures so that our audit risk is minimised. This may involve using more experienced staff, carrying out procedures nearer to year-end and carefully choosing more effective testing procedures. In addition to the references to ASA 200 above, it might it helpful to preview ASA 330.6-7, A4-A19 in relation to this point.
I hope that you can see how you are continuing to “apply” the principles you have been learning.