The purpose of this memorandum is to outline in sufficient detail the terms of the audit engagement. In planning the audit engagement for Toy Local Corporation for the year ended October 31, 2012. This memorandum has been arranged according to the envisioned audit strategy and is centered on collective audit data and practice. As well as important matters that address significant engagement issues, and particularly identifies matters applicable to the attention of the audit committee.
Business risk is one of the four critical components of risk involved in conducting an audit. It originates with the audit client and its environment; it is the risk that affects the operations and possible outcomes of organizational activities. The business risks identified in the Toy Local Company are the following:
- Economic climate- a company is always at risk of the economy, especially in an economy that is coming out of a recession.
- Technological change- It is stated in last year's observations that the Cuddle Bears' success had to do with their electronic-based facial features, there is a risk that competitors will develop a different electronic-based feature that will captivate the consumers this year.
- Competition- TLC is a small company compared to their competitors and therefore competition is considered a risk due to their size.
- Geographic Location- The geographic location of TLC's manufacturing facilities affected the potential sales of the Cuddle Bears last year and therefore pose a higher risk to the success of their sales this year due to the retailer's new time demands.
The risk an auditor has when expressing an inappropriate audit opinion when the financial statements are materially misstated is considered to be audit risk.There are two ways an auditor can control this risk: First way is to completely avoid the audit risk by not accepting certain companies as clients, and second way is to set a low audit risk level and increase the amount of testing in order to lower the risk of failing to identify any material financial misstatements. The identified audit risks in TLC were the following:
- Management Integrity- Management's integrity is questioned because of the $10,000 "gesture of support" given to the International Workers Transport Union in hopes of ending talks about work stoppages and strikes in late fall/winter 2012.
- Independence of management- It is stated in the Findings from Interim Audit Procedures Conducted in July and August 2012 that the CFO approved the recording of a $100,000 recovery owed by Kmart on 7/31/2012 and he initiated the journal entry transaction. These actions by a CFO raise red flags.
- Quality of the organization's risk management process and controls- TLC's management processes and controls come into question when a staff member claimed that she enjoyed an inventory count of Hard Toy Action Figures because she was pleased to see Soft Toy Cuddle Bears. If a staff member does not know how to differentiate between products then how can we trust any of their inventory counts.
- Failure to follow Financial Reporting Standards- TLC accrued $500,000 of sales revenue when they signed a movie contract when only $300,000 would be compensated if certain toy sales are not reached.
Conclusion: Other risks involved are new product failure, doubling of management's bonus pool contributions depending on TLC's operating income gives management incentive to cook the books in order to meet certain numbers, and management competence.