Text PAQ 4.33

Determining audit strategy

Required

(a) Identify the factors that would affect the preliminary assessment of inherent risk and control risk at Princess Island Vineyards.

(b) Explain how these factors would influence your choice between the predominantly substantive approach and the lower assessed level of control risk approach for sales, inventory and debtors.

a. Factors affecting preliminary assessment of inherent risk include:

• Wine is vulnerable to storage conditions (temperature), suggesting high risk of spoilage, affecting inventory valuation.
• Boutique wine operation – highly skilled processes requiring skilled staff (winemaker), reliant on few customers?
• Export sales, foreign exchange transactions – complicated transactions with risk of incorrect pricing, risk assessment.
• Tourism based sales at shop and café – fluctuating demand?
• Competing incentives for export sales and café consulting businesses.
• Heavy reliance on export sales increases vulnerability of business to this source of revenue, and making product available to meet this demand.

Factors affecting preliminary assessment of control risk include:

• Effectiveness over quality control over wine production and storage, affecting saleability of product (although quality control is apparently high).
• Risk of product spoilage, affecting value of inventory.
• Controls over sales made by Jim, documentation, pricing, sales allowances.
• Lack of communication between Jim and brother Bob and other staff – affecting efficiency and effectiveness of management.

b Lower assessed level of control risk approach is appropriate when control risk is assessed as low while predominantly substantive approach is appropriate when control risk is assessed as high, and it is more efficient not to rely on controls.

For Sales:

The poor communication between Jim and other management and staff, plus his competing incentives and the lack of control over his actions means that control risk in these areas would be considered high. The validity of sales transactions, including the amounts and terms of the sale, is at risk. There is also a risk that sales made to customers are not entered correctly in the accounts.

Control risk for sales and debtors is high, meaning that the predominantly substantive approach would be adopted in these areas.

For Inventory:

Control over production appears to be good, and inventory quality seems to be high. However, the inherent risk of inventory spoilage is reasonably high. This suggests that a lower assessed level of control risk could be adopted for inventory. Testing the controls over inventory, and obtaining satisfactory results, would mean that less substantive testing would be required.

For Debtors:

A predominantly substantive approach for sales is more appropriate because the adjustments to debtor accounts do not appear to be adequately controlled. Rather than developing and implementing a policy and procedures on credit notes, Jim frequently issues credit notes to clients who complain about their statement without investigating it. Also the lack of resources to follow company’s protocol (i.e. Jim is to too busy to respond to customer complaints) increases the control risk.