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Auditing (Management Fraud and Audit Risk)


Students will work on Exercise 4.65 (page 165). This assignment is to be typed with a one-page minimum submitted to me in a memo format as shown in Appendix B of this syllabus. This sample memo format is simply a framework to work from. To get a better understanding how to complete the entire audit memo, please refer to chapter four, Appendix B, Sample Audit Memorandum of Integrated Care Health Insurance Inc. This is a sample of how extensive you should complete your audit strategy memorandum. Exercise 4.65 requests that you use any public company. In order to be able to complete this assignment, you must choose a public company that interests you. Open up the latest 10-K and read what the business is all about, management’s discussion and analysis as well as the risk factors. You will become familiar with the potential risks that the company is faced with and with this new knowledge; you should be able to identify sources of risk. Once you gain an understanding of the business and have identified sources of risk, you should be able to piece together which assertions are relevant, which test of controls and substantive procedures you may want to focus on. Please stay focused in one or two areas. Since you are selecting a public company, you could potentially write an audit strategy memorandum that may be several pages long. Try to keep it no longer than the sample you find in Chapter four, Appendix B.
It is due by March 20th.

Audit Strategy Memorandum. The auditor should establish an overall audit strategy that sets the scope, timing, and direction of the audit and guides the development of the audit plan. In establishing the overall audit strategy, the auditor should develop and document an audit plan that includes a description of (a) the planned nature, timing, and extent of the risk assessment procedures, (b) the planned nature, timing, and extent of tests of controls and substantive procedures, and (c) other planned audit procedures that must be performed so that the engagement complies with auditing standards.
Select a public company and determine a significant risk that could affect its financial statements. (Hint: Go to the EDGAR database at and select the company’s form 10-K. The 10-K will have a list of risk factors the company faces). Describe the risk and how it could affect the financial statements, including what assertions might be misstated. Prepare an audit strategy memorandum for the risk describing what controls the company might use to mitigate the risk, how you could test the controls, and what substantive procedures you might use to determine whether there is a misstatement. Because this is early in your auditing class, do not worry about specific procedures; just be creative and think about a general strategy an auditor might use.

Appendix B
Sample Audit Memorandum
Integrated Care Health Insurance Inc. (Integrated) offers a variety of valuable products and services ranging from medical, dental, and behavioral health coverage to life insurance and disability plans as well as management services for Medicaid plans. Purchasing health coverage ensures future security with respect to high and unexpected costs of health care for individuals, families, and businesses. Benefits offered by Integrated include not only coverage for medical expenses but access to a wide network of doctors, hospitals, and specialists.

Integrated uses a special process to calculate premiums charged for services offered. The method involves pooling customers with similar characteristics into a single risk group based on age, gender, medical history, lifestyle, and other factors such as benefits desired, administration costs, and tax obligations. After Integrated pools customers into their respective risk groups, Integrated has the responsibility to balance projected future costs with premiums charged. The most important factor in determining financial success for Integrated is its ability to predict trends and future medical costs. Therefore, faulty forecasts can lead to huge risks and downfalls for Integrated if expectations fall short of actual results. Competing in an industry where new technology and medical breakthroughs are discovered almost daily means that sustaining profitability is an increasing concern.

Along with a great deal of risk being inherent in its business, Integrated has also been experiencing a strain in its operations due to the declining U.S. economy and increasing unemployment rate. Additionally, the health care reform legislation passed in 2009 will cause significant changes to many facets of the industry’s operation according to analysts. However, certain parts of the legislation leave providers with the hope of positive changes. For example, given that the new legislation will require coverage for those who are currently uninsured, the insurance companies will acquire millions of new customers virtually overnight. Nevertheless, the total effect on the reform is still uncertain because a bulk of the legislation passed will not become effective until 2014 to 2016.

Integrated’s customers include employer groups, self-employed individuals, part-time and hourly workers, governmental organizations, labor groups, and immigrants. Although there are a considerable number of companies competing, experts have noted a trend that competition is virtually disappearing due to the domination of markets by only a few providers. In a study published by the American Medical Association, 24 of 43 states have one or two insurers comprising a market share of a staggering 70 percent.7 These statistics may suggest that there is essentially no competition in the market. However, 1,300 companies are competing in the health insurance industry, and Integrated faces significant competition in highly concentrated markets. In addition to the competition and governmental influences already present, Integrated is also facing competition from hospitals that play a pertinent role in determining the amounts billed for services provided.

Page 169
The following analysis provides an overview of the identified risks and expected controls for Integrated for one accounting cycle.

Due to the contract nature of the insurance industry, revenue recognition is not a high-risk area when compared to other industries. Integrated has set contracts with commercial organizations, individuals, and the government. Therefore, large fluctuations throughout the year do not typically occur. However, one area of significant risk involves the Medicare risk adjustment. The Centers for Medicare & Medicaid Services (CMS) determines Medicare and Medicaid premium payments employing a risk-based formula using coding provided by the insurance companies based on data from the diagnosis. Members with Medicare and Medicaid benefits associated with the health insurance entity is given a risk category based on their health conditions. However, because these contracts are preset for a year, patients’ risk categories might fluctuate, causing an increase in needed payment from the CMS. Integrated must ensure that revenue is recognized properly by recording a risk adjustment for the difference between what CMS paid and what should have been paid based on the appropriate risk categories. CMS also performs audits known as Risk Adjusted Data Validation (RADV) audits to ensure CMS remits premium payments to insurance organizations appropriately.

Another area of significant risk around revenue recognition involves the Medicare Part D risk-sharing provision. With Medicare Part D, insurance entities contract with CMS for set premiums on an annual basis. The ultimate payment of total premiums, however, depends on certain thresholds that might require additional payment by CMS or reimbursement to CMS. A reconciliation (true-up) is performed after year-end to account for these differences. However, because this true-up process might occur six to nine months after year-end, Integrated must account for this process by recording receivables or payables that estimate these differences. Significant estimates are used to develop these adjustments and requires the company to plan the audit procedures to provide reasonable assurance that these estimates do not include material misstatements.

The difficulty in predicting revenue adjustment amounts from these two programs concerns Integrated management’s assertions of completeness, accuracy, valuation of financial statement accounts, and proper disclosure of required revenue recognition elements. To meet disclosure assertions, Integrated established a disclosure committee to determine what revenue-related disclosures should be made regarding Medicare and Medicaid. This committee meets prior to the release of each quarter’s financial statements or as often as management requires. Valuation and accuracy assertions are met by requiring that qualified personnel utilize acceptable models commonly used in industry practice when estimating the amounts for the varying revenues. Appropriate supervisors review all estimates for accuracy and verify that estimates conform to the company’s operational objectives.

Due to the high-risk nature of the unique business and audit risks detailed here, an audit plan for Integrated must include both test of controls and substantive procedures to provide for the appropriate level of detection risk. As mentioned, significant estimates are included in the financial statements for almost every accounting cycle within the health insurance industry. The amount of management judgment needed to determine these estimates requires the use of extensive substantive testing to provide reasonable assurance that material misstatements do not exist within the financial statements. The following detailed audit plan provides guidance on the types of control testing and substantive testing that would provide reasonable assurance that material misstatements do not exist in relation to the risks outlined within this report.

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