Exercise 3-2 (Exhibit 3-8)

Overall Inherent Risk Level

Client: The Lakeside Company

Balance Sheet Date: December 31, 2011
Prepared by: Jordan Kerester

Inherent risk (IR) is a measure of the susceptibility of material misstatement before considering the effectiveness of the
internal control. Determine the appropriate level of inherent risk for the audit engagement as a whole, using qualitative
terms (high, moderate or low inherent risk). Complete the following table.

Factor Discussion Low Moderate High

Nature of client’s business Consumer electronics industry is subject to swings in the X
economy and is very competitive.

Results of previous audits
Initial versus repeat engagement
Quantity of related party transactions
Quantity of non-routine transactions
Quantity of estimates and judgment
required for accounts
Potential for fraudulent financial
reporting (fraud risk factors)
Potential for misappropriation of
assets (fraud risk factors)
The previous auditor issued a qualified opinion due to X
impairment. Rogers disagreed with this opinion, but refused
to write down the value of the sixth store.
This is the first year that we are auditing Lakeside. X
Rogers owns a construction company that will be building
store number seven. The companies are not independent
from each other and this will affect the financial statements X
once the store is build.
There are few non-routine transactions to consider. X
Rogers refuses to acknowledge that there is any impairment X
on the sixth store and refuses to write down its value. This
creates a higher risk. There are few other accounts to
consider.
A recent bonus system was introduced that could make the X
creation of false sales seem enticing. Sales could be
recorded at false dates to increase sales for the year ends.
Since the inventory levels are very high, it would be easy for X
any employee with access to take something and cover it up.
Other factors (list) With Cypress being the only supplier for Lakeside, they X
Supplier relations would have a hard time getting inventory if Cypress ever
faced financial trouble.
Other factors (list) Lakeside has large amounts of outstanding credit, and
Bank credit interest interest rates fluctuant. If they ever went to high, it would be X
difficult for Lakeside to pay off short-term liabilities.
Conclusion: Overall inherent risk level Discussion for overall level is below. X

Discussion: Discuss how you arrived at this overall level of inherent risk.
Since this is the first year we are doing this audit, there is a high level of risk involved. This will have an impact on the level of
planned detection risk, which means we will have to gather more evidence for Lakeside.