CPA Exam — AUDAssessing Risk and Developing a Planned ResponseMedium
An auditor is evaluating the overall audit strategy for a new client, a start-up technology company that has received significant venture capital funding but has yet to generate substantial revenue. Which of the following factors would most likely lead the auditor to initially assess inherent risk as high?
- AThe company's strong control environment with experienced management.
- BThe company's use of industry-standard accounting software.
- CThe reliance on complex revenue recognition criteria for future service contracts.
- DThe presence of a strong internal audit function.
Show answer & explanationAnswer & explanation
Correct answer: C. The reliance on complex revenue recognition criteria for future service contracts.
Complex revenue recognition criteria, especially for future service contracts in a start-up environment with limited operating history, present a higher susceptibility to material misstatement before considering internal controls. This directly increases inherent risk.
Why the other options are wrong
- A. A strong control environment with experienced management would tend to reduce control risk, not increase inherent risk.
- B. Using industry-standard software can improve control and consistency, generally reducing risk, not increasing inherent risk.
- D. A strong internal audit function would typically reduce control risk by monitoring internal controls, not increase inherent risk.
Inherent Risk Factors (Complexity)
Inherent risk is higher for transactions, accounts, or disclosures that are complex, involve significant judgment, or are subject to external factors.
- Complex calculations or accounting principles increase inherent risk.
- Estimates and subjective judgments are prone to higher inherent risk.
- New business models or unusual transactions often carry higher inherent risk.
Memory trick: Inherent risk is 'C'omplex, 'U'nusual, or 'E'stimates.