Risk of Material Misstatement for Tangible Asset
Risk of material misstatement for tangible asset is the risk that there is a material misstatement in the tangible asset account, but the internal control procedures cannot prevent or detect such misstatement from occurring.
As the risk of material misstatement comes entirely from the inherent risk and control risk, the level of risk of material misstatement for tangible asset will depend solely on the susceptibility of tangible asset account to misstatement and the related internal controls in place to prevent or detect such misstatement.
In short, inherent risk and control risk of tangible asset will decide whether the level of its risk of material misstatement will be high, moderate, or low.
And the level of risk of material misstatement will decide the substantive procedures that auditors perform in the audit. Hence, if the risk of material misstatement for tangible asset is high, auditors may have to perform more substantive procedures in order to reduce the audit risk related to the asset.
Inherent Risk of Tangible Asset
Inherent risk is the risk of material misstatement on accounts or balances before considering any control procedures. It is the susceptibility of an account or balance to misstatement.
In this case, inherent risk of tangible asset is the risk that tangible asset accounts contain material misstatement before putting any control in place.
The level of inherent risk is based on the nature and type of the client’s business. Likewise, if the client’s business has a lot of unusual and complex transactions and requires a high degree of judgment, we can conclude that there is a high level of inherent risk here.
Examples of inherent risk of tangible asset may include:
- Cost that should be recognized as expenses has been capitalized as an asset which results in the overstatement of total assets and net profit
- Unreasonable useful life of assets may be used to increase the profit by reducing the depreciation expense
- Inappropriate depreciation method, which does not reflect the actual economic impairment, may be used
- Asset may be misappropriated by the client’s staff
- Asset may not be removed from the balance sheet after disposal
- The client may not record the disposal of asset
- Incorrect recording of assets, e.g. due to complexity of assets’ ownership structures
- The obsolescence of assets may not be taken into account when the client assesses the fair value of the tangible assets, etc.
Control Risk of Tangible Asset
Control risk is the risk that the client’s internal controls cannot prevent or detect material misstatement that occurs on the financial statements. In this case, the control risk of tangible asset is the risk that tangible asset accounts contain material misstatement, but the related control procedures cannot prevent or detect such misstatement.
After identifying the inherent risk of tangible asset, auditors usually assess whether there are strong and effective controls in place to prevent or detect such risk. In other words, they usually try to assess whether the control risk is low so that they can rely on internal control to reduce some of their substantive works.
However, auditors need to perform test of controls to obtain sufficient appropriate audit evidence to support their assessment that the control risk is low. On the other hand, if they assess that the control risk is high, they don’t need to perform the test of controls.
In this case, they will go directly to substantive procedures (e.g. by performing more works). After all, there is no point of trying to prove that the control risk is high.
It is useful to note that auditors cannot influence inherent risk or control risk. They can only modify detection risk based on the level of risk of material misstatement so that they can reduce audit risk to an acceptably low level.
In this case, when inherent risk is high, internal control is the only factor that can reduce the risk of material misstatement for tangible asset to some extent.
Examples of the internal control procedures that can reduce the risk of material misstatement for tangible asset may include:
- Proper authorization of each acquisition and disposal of tangible asset
- Regular reconciliation of tangible asset listing to the general ledger
- Periodic physical inspection of tangible assets (e.g. twice a year)
- Appropriate classification of tangible assets based on their expected useful life
- Periodical reassessment of the depreciation used to see if it is still reasonable and appropriate (e.g. based on the past performance of the asset)
- Proper policy on identifying and writing down the value of assets that are obsolete
- Monthly performance review (e.g. comparing actual tangible assets to the budget plan and investigate any significant variance)
- Periodical assessment of impairment of tangible assets, etc.