ACCT 250 – Principles of Auditing

Spring 2022, Section 1

Handout– Chapter 6
Risk Assessment

Question 1 (25 minutes – 16 points)

Dog Lovers Inc. (DLI) is the manufacturer and seller of dog food. The company has strong
financial performance in the past and has expanded rapidly over the years. Due to the recent
increased product demand and anticipated future expansion, DLI’s owners decided to construct a
new manufacturing facility and warehouse on a previously owned but unused piece of land. In
order to raise funds for the planned expansion, DLI decided to approach its bank to borrow
Rs.650 million for the construction. Most of the company’s products are well-received in the
market but food authorities have recently raised concerns about potentially harmful contents
present in pet foods manufactured by most companies in the country.

Based on the positive income and performance of DLI in the past, the bank agreed to finance the
construction by advancing the funds in four equal quarterly instalments, with the first advance to
be made on May 1, 2022. DLI will have to provide audited financial statements prepared in
accordance with IFRS for the year ended December 31, 2021, and will likely have some
covenants to meet.

The turnover of personnel at DLI has been significant over the years, especially in the accounting
and finance department. DLI had a new finance officer start in September 2021. On October 30,
2021, DLI sold damaged equipment for Rs.200,000, which had an original cost of Rs.800,000
and net book value of Rs.500,000. He recorded a loss of Rs.600,000 on the asset disposal. The
finance officer also calculated depreciation expense for the year ended December 31, 2021.

The CFO of DLI is generally satisfied that the internal control processes designed in 2014 are
being followed at DLI, however, she mentioned that she found a few exceptions. She also
recognizes that due to expanding business, certain changes had to be made to the original
processes for efficiency purposes. Since the company could not afford a permanent internal
auditor, she has hired a professional services firm to take a fresh look at processes and controls,
beginning in June 2022.

According to the draft financial statements for the year ended December 31, 2021, DLI reported
total assets of Rs.490 million, total liabilities of Rs.270 million, revenues of Rs.870 million,
finance (interest) costs of Rs.14 million, pre-tax income of Rs.94 million and net income of
Rs.70.5 million.

It is now February 28, 2022, and DLI, has hired Husayn & Co to perform the first-time audit of
DLI’s financial statements, as required to obtain the loan. Husayn & Co has very little
experience in pet-food industry. Being a busy season, the audit firm wants to complete this
assignment as soon as possible, in order to concentrate on other more lucrative jobs.

You, CA, work for Husayn & Co. The engagement partner asks you to assess EIGHT risks of
material misstatement indicating if the risk can be classified as inherent, control or detection risk.
He has also asked you to comment on an appropriate benchmark for determining materiality, as
well as calculating a preliminary materiality number.