Question

research at least two (2) companies that have experienced downgrades related to stock performance or bond ratings within the last five (5) years. Next, analyze the primary ways in which auditors would use the information from downgrades to assess business risk or evaluate the likelihood that the downgrades would impact the auditor's assessment of the client's business environment. Ascertain the major ways in which this information would impact the audit risk model equation. Support your position. According to an article in the CPA Journal, the auditor considers reliability of audit evidence collected and the reliability of that evidence to reduce the risk of financial statements containing undetected material errors. Compare and contrast at least two (2) types of evidence, and make a recommendation as to which you believe is the most reliable in reducing risk. Support your position.

Answer 1

Two companies that have experienced downgrades related to stock performance or bond ratings in last 5 years are -

1. Tesla Inc., which is an American automotive and energy company.

Moody's Investors Service downgraded Tesla Inc. rating to B3 from B2, unsecured note rating to Caa1 from B3, and Speculative Grade Liquidity rating to SGL-4 from SGL-3. The outlook is negative.

1. Exxon Mobil Corp., is an American multinational oil and gas corporation.

Standard and Poor's downgraded ExxonMobil's credit rating from AAA to AA+. the outlook for the same is negative.

Downgrade of a company is mostly because of their deteriorating finances, high debt levels, weak liquidity position of the company. So,​​​​the auditor should try to understand the reasons for such downgrade. The primary ways in which auditors would use the information from downgrades to assess business risk -

1. Get an understanding of

• The nature of the company i.e. what are its operations, its ownership structure, governance structure
• Sources of finance of the company
• Company's business strategy i.e how do they maximize the shareholder's profitability at the same time serving the community​​​​​​​​​​​​​​​​​​​​​

​​​​​​​ 2. Reviewing the company's financial performance thoroughly.

3.Regulatory agency who regulate the company

4. Observing the client at work

5. Inquiring the employees about the management

The audit risk model determines the total amount of risk associated with an audit, and describes how this risk can be managed​​​​​​​.

Audit risk = Control risk x Detection risk x Inherent risk​​​​​​​

Thus, the elements of audit risk model are -

• Control Risk - It the risk of a material misstatement in the financial statements arising due to absence or failure in the operation of relevant controls of the company.
• Detection Risk - It is the risk that the auditor will not detect a material misstatement that exists in an assertion.
• Inherent Risk - This risk is caused by an error or omission arising from factors other than control failures.

​​​​​​​The information about the downgrade would impact the audit risk model equation​​​​​​​ in the following way -

While conducting an audit, the auditor must review each level of risk thoroughly to determine the total amount of audit risk. If the risk level is too high (as in the case of downgraded company), the auditor conducts additional procedures to reduce the risk to an acceptable level. This model has an important implication for auditors. Auditors can only control detection risk, because inherent risk and control risk are the responsibilities of management. When the level of control risk and inherent risk is high, the auditor can increase the audit procedures or reduce tolerable misstatement, thereby reducing detection risk. Alternatively, if the inherent and control risks of a company is low, detection risk is allowed to be set at a relatively higher level by the auditor.

The reliability of the information which is used as an audit evidence, is influenced by source and the nature of the evidence itself. So, we need to study the 2 types of evidence thoroughly.

These are -

1. Internal Evidence
2. External Evidence

​​​​​​​Comparison between these two evidence types -

1. Internal Evidence originates within the company i.e. the proof which is there within the comapny. For example vouchers, sales invoice etc. While, External Evidence does not originate from the company's records For example supplier's note, tax invoice, purchase invoice.
2. Auditor does not have to look anywhere to obtain internal evidence. They are readily available with the company. External evidence is available to third parties or outside parties and the auditor has to check for those from the third parties.
3. The biggest advantage of internal evidence is that auditor does not need to go anywhere the information is available from single point. The biggest benefit of external evidence is that since it involves third parties this information is more accurate. ​​​​​​​
4. The disadvantage of the internal evidence is the reliability factor and for the external evidence is that the auditor needs to follow up and go to third parties in order to obtain this information which may delay the auditing of the firm.
5. Risk Assessment Procedure adopted by the auditor in internal evidence is enquiries with management or employees, self observing. While the procedures adopted for external evidence is enquiries with banks, debtors of the company etc.

​​​​​​​From the above discussion, it is clear that although internal evidence is easily available when compared to external evidence but the reliability factor needs to be considered. Internal evidence can easily be forged by the company. As external evidence is more accurate, we need to rely on those for correct information about the company.