Presumed Significant Risk

Question 1

Presumed significant risk

Answer 1

Presumed Significant Risk on Revenue Recognition

Revenue recognition is a presumed significant risk for fraudulent financial reporting.

Reasons for the Risk

1. Overstatement of revenue: Premature revenue recognition, recording fictitious revenues, or improper accounting for multiple-element arrangements.
2. Understatement of revenue: Improperly shifting revenues to a later period.

Factors Increasing the Risk

1. Pressure or incentives: Management pressure to meet performance targets or incentives that encourage aggressive revenue recognition.
2. Complexity: Multiple revenue streams, complex transactions, or unusual revenue recognition practices.

Rebutting the Presumption

The auditor may rebut the presumption of a significant risk if:

1. Simple revenue transactions: A single type of simple revenue transaction, such as leasehold revenue from a single unit rental property.
2. Low risk environment: The auditor concludes that the risk of material misstatement due to fraud relating to revenue recognition is low.

Here’s a revised version with headings:

Summary of Presumed Significant Risk on Revenue Recognition

The auditor is required to presume that there is a significant risk of material misstatement due to fraudulent financial reporting in revenue recognition, unless the presumption is rebutted. This presumption is based on the fact that revenue recognition can be complex and subjective, and management may have incentives to manipulate revenue. The auditor must assess the risk of material misstatement due to fraud in revenue recognition and design audit procedures to address those risks.

Explanation of Presumed Significant Risk on Revenue Recognition

The concept of presuming a significant risk of material misstatement due to fraudulent financial reporting in revenue recognition is based on the idea that revenue recognition is a critical area in financial reporting, and management may have incentives to manipulate revenue to achieve certain financial goals. This manipulation can take many forms, including premature revenue recognition, fictitious revenues, or improper shifting of revenues to a later period.

The auditor’s responsibility is to assess the risk of material misstatement due to fraud in revenue recognition and design audit procedures to address those risks. This requires the auditor to obtain an understanding of the entity’s revenue recognition policies and procedures, assess the risk of material misstatement due to fraud, and design audit procedures to address the identified risks.

Examples of Presumed Significant Risk on Revenue Recognition

1. Premature Revenue Recognition: A software company recognizes revenue from a contract before the software has been delivered to the customer. This is an example of premature revenue recognition, which can be a form of fraudulent financial reporting.
2. Fictitious Revenues: A company recognizes revenue from a fictitious customer or transaction. This is an example of fictitious revenues, which can be a form of fraudulent financial reporting.
3. Improper Shifting of Revenues: A company shifts revenues from one period to another to avoid recognizing losses or to smooth out earnings. This is an example of improper shifting of revenues, which can be a form of fraudulent financial reporting.
4. Complex Revenue Recognition: A company has complex revenue recognition policies and procedures, such as multiple revenue streams, contracts, or transactions. This complexity can create opportunities for management to manipulate revenue, which can be a form of fraudulent financial reporting.
5. Pressure or Incentive on Management: A company’s management is under pressure to meet certain financial targets, such as earnings per share or revenue growth. This pressure can create an incentive for management to manipulate revenue, which can be a form of fraudulent financial reporting.

Rebutting the Presumption of Significant Risk on Revenue Recognition

The presumption of significant risk of material misstatement due to fraudulent financial reporting in revenue recognition can be rebutted if the auditor determines that the risk is low. This can occur if the entity has:

1. Simple Revenue Transactions: The entity has a simple revenue recognition process, such as a single revenue stream or a small number of transactions.
2. Robust Internal Controls: The entity has robust internal controls over revenue recognition, such as automated systems, regular reviews, and approvals.
3. Low Pressure or Incentive on Management: The entity’s management is not under pressure to meet certain financial targets, or there are no incentives to manipulate revenue.

In these cases, the auditor may determine that the risk of material misstatement due to fraud in revenue recognition is low, and the presumption of significant risk can be rebutted. However, the auditor must still design audit procedures to address the risks of material misstatement due to fraud in revenue recognition.