Risk

Audit risk

 

One of the main requirements of the audit is for the auditor to:

 



‘…obtain sufficient appropriate evidence to reduce audit risk to an acceptably low level…’

 

[ISA 200 Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with ISAs, 17]

 

Audit risk is the risk that the auditor expresses an inappropriate opinion when the financial statements are materially misstated.

 

[ISA 200, 13]

 

This means that they give an unmodified audit opinion when the financial statements are materially misstated.

Audit risk comprises the risk of material misstatement and detection risk.

 

Risk of material misstatement is the risk that the financial statements are materially misstated prior to the audit. [ISA 200, 13ni]

 

This will be due to fraud or errors occurring during the year when transactions have been processed or when the financial statements have been prepared.

 

ISA 315 (Revised) Identifying and Assessing the Risks of Material Misstatement Through Understanding the Entity and its Environment states:

 

‘The objective of the auditor is to identify and assess the risk of material misstatement, whether due to fraud or error, at the financial statement and assertion levels, through understanding the entity and its environment, including the entity’s internal control, thereby providing a basis for designing and implementing responses to the assessed risks of material misstatement.’ [ISA 315, 3]

 

What is a misstatement?

 

‘A difference between the amount, classification, presentation, or disclosure of a reported financial statement item and the amount, classification, presentation, or disclosure that is required for the item to be in accordance with the applicable financial reporting framework. Misstatements can arise from error or fraud.’

 

[ISA 450 Evaluation of Misstatements Identified During The Audit, 4a]

 

In conducting a thorough assessment of risk, auditors will be able to:

 

• Identify areas of the financial statements where misstatements are likely to occur early in the audit.

 

• Plan procedures that address the significant risk areas identified.

 

• Carry out an efficient, focused and effective audit.

 

• Reduce the risk of issuing an inappropriate audit opinion to an acceptable level.

 

• Minimise the risk of reputational and punitive damage.

 

Categories of misstatement

 

There are three categories of misstatements:

 

• Factual misstatements: a misstatement about which there is no doubt.

 

• Judgmental misstatements: a difference in an accounting estimate that the auditor considers unreasonable, or the selection or application of accounting policies that the auditor considers inappropriate.

 

• Projected misstatements: a projected misstatement is the auditor’s best estimate of the total misstatement in a population through the projection of misstatements identified in a sample.

 

[ISA 450, A6]

 

The risk of material misstatement comprises inherent risk and control risk.

 

Inherent risk

 

Inherent risk is the susceptibility of an assertion about a class of transaction, account balance or disclosure to misstatement that could be material, before consideration of any related controls.

 

[ISA 200, 13ni]

 

• Complex accounting treatment is an example of an inherent risk. For example, where an accounting standard provides guidance on a specific accounting treatment this might not be understood by the client and material misstatement could result.

 

• Inherent risk may arise due to the nature of the industry, entity or the nature of the balance itself. For example, inventory is inherently risky if it quickly becomes obsolete as it may not be valued appropriately at the lower of cost and NRV as required by IAS 2 Inventories.

 

Control risk

 

Control risk is the risk that a misstatement that could occur and that could

 

be material will not be prevented, or detected and corrected on a timely

basis by the entity’s internal controls.

[ISA 200, 13nii]

 

Control risk may be high either because the design of the internal control system is insufficient in the circumstances of the business or because the controls have not been applied effectively during the period. This is covered in more detail in the  ‘Systems and controls’.

 

Detection risk

 

Detection risk is the risk that the procedures performed by the auditor to reduce audit risk to an acceptably low level will not detect a misstatement that exists and that could be material. [ISA 200, 13e]

 

Detection risk comprises sampling risk and non-sampling risk:

 

• Sampling risk is the risk that the auditor’s conclusion based on a sample is different from the conclusion that would be reached if the whole population was tested, i.e. the sample was not representative of the population from which it was chosen. [ISA 530 Audit Sampling, 5c]

 

• Non-sampling risk is the risk that the auditor’s conclusion is inappropriate for any other reason, e.g. the application of inappropriate procedures or the failure to recognise a misstatement.

 

The auditor must amend the audit approach in response to risk assessment to ensure they detect the material misstatements in the financial statements.

 

They can achieve this by:

 

• Emphasising the need for professional scepticism.

 

• Assigning more experienced staff to complex or risky areas of the engagement.

 

• Providing more supervision.

 

• Incorporating additional elements of unpredictability in the selection of further audit procedures.

 

• Making changes to the nature, timing or extent of audit procedures, e.g.

 

–  Placing less reliance on the results of systems and controls testing.

 

–  Performing more substantive procedures.

 

– Consulting external experts on technically complex or contentious matters.

 

–  Changing the timing and frequency of review procedures.

 

[ISA 330 The Auditor’s Response to Assessed Risks, A1]

 

Professional scepticism

 

Professional scepticism is: ‘An attitude that includes a questioning mind, being alert to conditions which may indicate possible misstatement due to fraud or error, and a critical assessment of audit evidence.’ [ISA 200, 13l]

 

Clearly this requires the audit team to have a good knowledge of how the client’s activities are likely to affect its financial statements. The audit team should discuss these matters in a planning meeting before deciding on the detailed approach and audit work to be used.

 

How to apply professional scepticism

 

Professional scepticism requires the auditor to be alert to:

 

• Audit evidence that contradicts other audit evidence.

 

• Information that brings into question the reliability of documents and responses to enquiries to be used as audit evidence.

 

• Conditions that may indicate possible fraud.

 

• Circumstances that suggest the need for audit procedures in addition to those required by ISAs.

 

[ISA 200, A20]

 

 

Exercising professional scepticism

 

The auditor identifies a customer of a client is having financial difficulties and has not paid any invoices for 6 months when the client’s credit terms are 10 days. The auditor may make an enquiry of management regarding the outstanding debt and their view on whether it should be written off.

Management may inform the auditor that they believe the debt will be paid as they have never experienced bad debts with this customer in the past. As a result they do not intend to write it off or make any allowance for it. Application of professional scepticism would require the auditor to seek alternative, corroborative evidence to support management’s claim as management may not want to allow for the debt as this will reduce profit. The auditor could review bank statements post year-end to identify if payment has been made. The auditor could also review any correspondence between the customer and the client indicating when payment might be made. Both of these procedures provide more reliable evidence than an enquiry with management who may tell the auditor what they think the auditor wants to hear to avoid an adjustment to the financial statements being suggested. Similarly, obtaining a written representation from management would not be appropriate as this is only marginally more reliable than an enquiry. Client generated evidence is always the least reliable form of evidence and the auditor should always look for better quality evidence where possible due to the risk of management bias.

 

2      Materiality

 

What is materiality?

 

‘Misstatements, including omissions, are considered to be material if they, individually or in the aggregate, could reasonably be expected to influence the economic decisions of users taken on the basis of the financial statements.’

 

[ISA 320 Materiality in Planning and Performing an Audit, 2]

 

What is the significance of materiality?

 

If the financial statements contain material misstatement they cannot be deemed to show a true and fair view.

 

As a result, the focus of an audit is identifying the significant risks of material misstatement in the financial statements and then designing procedures aimed at identifying and quantifying them.

 

How is materiality determined?

 

The determination of materiality is a matter of professional judgment. The auditor must consider:

 

• Whether the misstatement would affect the economic decision of the users

 

• Both the size and nature of misstatements

 

• The information needs of the users as a group.

 

Materiality is a subjective matter and as such should be considered in light of the client’s circumstances.

 

Material by size

 

ISA 320 recognises the need to establish a financial threshold to guide audit planning and procedures. For this reason the following benchmarks may be used as a starting point:

 

• ½ – 1 % of revenue

 

• 5% – 10% of profit before tax

 

• 1 – 2% of total assets.

 

The above are common benchmarks but different audit firms may use different benchmarks or different thresholds for each client.

 

 

Material by nature

 

Materiality is not just a purely financial concern. Some items may be material by nature.

 

Examples of items which are material by nature or material by impact include:

 

• Misstatements that affect compliance with regulatory requirements.

 

• Misstatements that affect compliance with debt covenants.

 

• Misstatements that, when adjusted, would turn a reported profit into a loss for the year.

 

• Misstatements that, when adjusted, would turn a reported net-asset position into a net-liability position.

 

• Transactions with directors, e.g. salary and benefits, personal use of assets, etc.

 

• Disclosures in the financial statements relating to possible future legal claims or going concern issues, for example, could influence users’ decisions and may be purely narrative. In this case a numerical calculation is not relevant.

 

 

Illustration 1 – Murray Co materiality

 

Financial Statement Extracts	20X4	20X3
	$000	$000
Revenue	21,960	19,580
Total assets	9,697	7,288
Profit before tax	1,048	248

 

Materiality	Lower	Upper
Revenue	½ %	1%
	110	220
Profit before tax	5%	10%
	52	105
Total assets	1%	2%
	97	194

 

• suitable range for preliminary materiality is $97,000 – $105,000.

 

Materiality is not normally based on revenue, except in circumstances when it would not be meaningful to base materiality on profit,

 

e.g. because the entity being audited is a not-for-profit entity or where there is a small profit (or a loss) as this will result in over-auditing of the financial statements (such as was the case for Murray Co in the prior year).

 

More than $105,000 profit is material to the statement of profit and loss, therefore preliminary materiality is likely to be set lower than this amount. Less than $ 52,000 is not material to profit (or to the statement of financial position) so preliminary materiality should not be less than this amount.

 

A suitable preliminary materiality level is most likely to be one that lies within the overlap of the ranges calculated for profit and total assets. $97,000 (1% of total assets) represents 9% profit. As this is at the lower end of the assets range, this would be a relatively prudent measure of materiality (resulting in a higher level of audit work).

 

$105,000 (10% of profit) represents 1.1% of total assets. Preliminary materiality might be set at this end of the range had this been a recurring audit. However, as this is a first audit, preliminary materiality is likely to be lower.

 

The financial statements are draft and therefore greater errors should be expected than if they were actual figures. Consequently, sample sizes for audit testing should be increased (i.e. preliminary materiality should be set at a relatively lower level).

 

Preliminary materiality is therefore likely to be set at $97,000.

 

Performance materiality

 

It is unlikely, in practice, that auditors will be able to design tests that identify individual material misstatements. It is much more common that misstatements are material in aggregate (i.e. in combination).

 

For this reason, ISA 320 introduces the concept of performance materiality.

 

Performance materiality is ‘The amount set by the auditor at less than materiality for the financial statements as a whole to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements exceeds materiality for the financial statements as a whole.’ [ISA 320, 9]

 

• The auditor sets performance materiality at a value lower than overall materiality, and uses this lower threshold when designing and performing audit procedures.

 

• This reduces the risk that the auditor will fail to identify misstatements that are material when added together.

 

3      Risk assessment procedures

 

The auditor should perform the following risk assessment procedures:

 

• Enquiries with management, of appropriate individuals within the internal audit function (if there is one), and others (with relevant information) within the client entity (e.g. about external and internal changes the company has experienced)

 

• Analytical procedures

 

• Observation (e.g. of control procedures)

 

• Inspection (e.g. of key strategic documents and procedural manuals). [ISA 315, 6]

 

Understanding the entity and its environment

 

In order to identify the risks of material misstatement in the financial statements the auditor is required to obtain an understanding of: their clients; their clients’ environments; and their clients’ internal controls. This generally includes:

 

• Relevant industry, regulatory and other external factors, including:

 

–  Financial reporting framework

 

–  Legislation and regulations

 

–  Competition

 

–  Economic conditions.

 

• Nature of the entity, including:

 

–  Nature of products and services

 

–  Ownership and governance structures

 

–  Investment and financing activities

 

–  Key customers and suppliers.

 

• Entity’s selection and application of accounting policies.

 

• Entity’s objectives, strategies and related business risks

 

–  Industry developments

 

–  New products and services

 

–  New accounting requirements

 

–  Current and future financing requirements.

 

• Measurement and review of the entity’s financial performance

 

– Performance measures and related incentives to commit fraud through management bias

 

–  Budgets, forecasts and variance analyses and performance reports

 

–  Comparison of performance with competitors

 

–  Consideration of performance related bonuses.

 

• Internal controls relevant to the audit (covered in more detail in the Systems and controls ).

 

[ISA 315, 11, A25 – A48]

 

If the entity has an internal audit function, obtaining an understanding of that function also contributes to the auditor’s understanding, in particular the role that the function plays in the entity’s monitoring of internal control over financial reporting. [ISA 315, A113]

 

The information used to obtain this understanding can come from a wide range of sources, including:

Analytical procedures

 

‘Evaluations of financial information through analysis of plausible relationships among both financial and non-financial data and investigation of identified fluctuations, inconsistent relationships or amounts that differ from expected values.’

 

[ISA 520 Analytical Procedures, 4]

 

Analytical procedures are fundamental to the auditing process.

 

The auditor is required to perform analytical procedures as risk assessment procedures in accordance with ISA 315 in order to:

 

• Identify aspects of the entity of which the auditor was unaware.

 

• Assist in assessing the risks of material misstatement in order to provide a basis for designing and implementing responses to the assessed risks.

 

 

• Help identify the existence of amounts, ratios, and trends

 

 

unusual transactions or events, and that might indicate matters that have audit

 

 

• Assist the auditor in identifying risks of material misstatement due to fraud.

 

[ISA 315, A14 & A15]

 

Analytical procedures include comparisons of the entity’s financial information with, for example:

 

• Comparable information for prior periods.

 

• Anticipated results of the entity, such as budgets or forecasts, or expectations of the auditor, such as an estimation of depreciation.

 

• Similar industry information, such as a comparison of the entity’s ratio of sales to accounts receivable with industry averages or with other entities of comparable size in the same industry.

 

[ISA 520, A1]

 

Analytical procedures also include consideration of relationships, for example:

 

• Among elements of financial information that would be expected to conform to a predictable pattern based on the entity’s experience, such as gross margin percentages.

 

• Between financial information and relevant non-financial information, such as payroll costs to number of employees.

 

[ISA 520, A2]

 

Computer assisted auditing techniques are now often used to perform data analysis.

 

Analytical procedures during the audit

 

Analytical procedures can be used at all stages of an audit.

 

ISA 315 requires the auditor to perform analytical procedures as risk assessment procedures in order to help the auditor to obtain an understanding of the entity and assess the risk of material misstatement.

 

ISA 500 Audit Evidence allows the auditor to use analytical procedures as a substantive procedure during the final audit to help detect misstatement.

 

In addition, ISA 500 requires the auditor to use analytical procedures at the completion stage of the audit when forming an overall conclusion as to whether the financial statements are consistent with the auditor’s understanding of the entity.

 

 

Key ratios

Profitability ratios

 

Gross margin: gross profit/sales revenue × 100%

 

Net margin: profit before tax/sales revenue × 100%

 

Auditors would expect the relationships between costs and revenues to stay relatively stable. Things that can affect these ratios include: changes in sales prices, bulk purchase discounts, economies of scale, new marketing initiatives, changing energy costs, wage inflation.

 

Therefore, any unusual fluctuation in the profitability ratio could mean that the figures are materially misstated. For example, if gross profit margin improves, this could be caused by any or all of the following:

 

• Overstated revenue because of inappropriate revenue recognition or cut-off issues.

 

• Understated cost of sales because of incomplete recording of purchases.

 

• Understated cost of sales because of overvaluation of closing inventory.

 

Efficiency ratios

 

Receivables days: receivables/revenue × 365

 

Payables days: payables/purchases × 365

 

Inventory days: inventory/cost of sales × 365

 

These ratios show how long, on average, companies take to collect cash from customers and pay suppliers and how many days inventory is held before being sold. Companies should strive to reduce receivables and inventory days to an acceptable level and increase payables days because this strategy maximises cash flow.

 

Any changes can indicate significant issues, such as:

 

• Worsening credit control and increased need for receivables allowance

 

• Slow-moving and possible obsolete inventory that could be overvalued

 

• Poor cash flow leading to going concern problems which would require disclosure.

 

Liquidity ratios

 

Current ratio: current assets/current liabilities

 

Quick ratio: (current assets-inventory)/current liabilities

 

These ratios indicate the ability of a company to meet its short term debts. As a result these are key indicators when assessing going concern.

 

Investor ratios

 

Gearing: borrowings/(share capital + reserves)

 

Return on capital employed (ROCE): profit before interest and tax/(share capital + reserves + borrowings)

 

Gearing is a measure of external debt finance to internal equity finance.

ROCE indicates the returns those investments generate.

 

Any change in gearing or ROCE could indicate a change in the financing structure of the business or it could indicate changes in overall performance of the business. These ratios are important for identifying potentially material changes to the statement of financial position (new/repaid loans or share issues) and for obtaining an overall picture of the annual performance of the business.

 

 4             Exam focus – Audit risk questions

 

Audit risk identification and explanation

 

Audit risk is regularly examined and it is important to answer the question from an auditor’s perspective rather than the perspective of the client.

 

The auditor is trying to detect material misstatements in the financial statements to avoid issuing the wrong opinion. The auditor is not looking to identify risks which affect the profitability of the client, they are not business consultants.

 

A common mistake that students make in exams is to explain business risks rather than audit risks. Business risks are not examinable in this syllabus. Therefore take care to ensure your answer is relevant to the requirement.

 

For example:

 

Factor	Audit risk	NOT Audit risk
		(business risk)
Customers are	Receivables may be	Bad debts may arise
struggling to pay debts.	overstated if bad debts	reducing the profits of
	are not written off.	the company.
The client operates in a	Inventory may be	Inventory may have to
fast paced industry.	overstated if the inventory	be written off reducing
	is obsolete and NRV is	the profits of the
	lower than cost.	company.
Revenue is falling due	If other factors are	Falling revenue will
to recession.	present, this could mean	result in reduced profits
	the company is unable to	and possible going
	continue to trade for the	concern issues.
	foreseeable future and
	going concern
	disclosures may be
	required. There is a risk
	that adequate disclosure
	is not made.

 

In the exam make sure your risks link with a risk of material misstatement or a detection risk.

 

A risk of material misstatement will affect either a balance in the financial statements, a disclosure in the notes to the financial statements or the basis of preparation.

 

Auditor responses to risks

 

Once the risks are identified, you must suggest a relevant audit response to the risk identified.

 

The response must specifically deal with the risk. You should not suggest audit responses that address the balance generally.

 

	Audit risk	Relevant	Irrelevant	Irrelevant
		response	response	response
	Overstatement of	Inspect after date	Obtain the	The risk identified
	receivables due	cash receipts from	receivables listing	is overvaluation.
	to bad debts not	customers to see if	and cast it to	Obtaining the
	written off.	paid post year-end	verify arithmetical	listing does not
		proving the debt is	accuracy.	provide evidence
		appropriately		that the debts are
		valued.		appropriately
		Review the aged		valued.
		receivables listing	Obtain external	External
		for old debts which	confirmation from	confirmation is
		may not be	customers to	providing
		recoverable and	confirm existence.	evidence of
		discuss the need		existence but not
		for an allowance to		valuation.
		be made with
			The company	This is a client
		management.
			should improve	response not an
			their credit control	auditor response.
			procedures.
	Overstatement of	Obtain the aged	The company	This is a client
	inventory due to	inventory listing	should discount	response not an
	obsolete items	and review for old	the inventory in	auditor response.
	not written off.	items. Discuss with	order to sell it.
		management the
		need for these to
		be written down in
		the financial
		statements.

 

			Attend the	As written, the
			inventory count to	response of
			confirm existence	attending the
			of the inventory.	inventory count is
				confirming
				existence, not
				valuation. This
				should be
				reworded to say
				attend the
				inventory count
				and look out for
				old or obsolete
				items that should
				be written down in
				the financial
				statements.
	Going concern	Assess the client’s	Perform an	Analysing past
	disclosures may	ability to continue	analysis of past	performance does
	not be adequate	as a going concern	performance and	not help indicate
	if the company	by examining the	assess the	how the company
	has trading	forecasts prepared	profitability of the	will perform in the
	difficulties.	by management	company.	future.
		and assess the	Calculate liquidity	Profitability is not
		reasonableness of	ratios.	the best indicator
		the assumptions		of going concern.
		used in the		Profits can be
		forecasts.
				distorted by
				accounting
				policies.
				A company can
				be profitable but
				not have sufficient
				cash available to
				pay its suppliers
				and employees.
				Calculation of
				ratios can help
				identify indicators
				of going concern
				problems but
				further procedures
				would need to be
				performed to
				obtain evidence of
				the company’s
				ability to continue
				to trade.

 

 

Test your understanding 1

 

Murray case study: Audit risks

 

Your firm Wimble & Co has recently accepted appointment as auditor of Murray Co (a manufacturer of sports equipment).

 

Having sold your shares in Murray Co, you have been assigned as audit manager and you have started planning the audit (although you were an employee of Murray Co, this was many years ago and you did not have any involvement in the preparation of the financial statements). You have held a meeting with the client and have ascertained the following:

 

Murray Co manufactures sports equipment. Most items of equipment, such as tennis rackets, hockey sticks and goals, take less than one day to manufacture. Murray Co’s largest revenue generating product, ergometers (rowing machines), takes up to one week to manufacture. Murray Co refurbished the assembly line for the ergometers during the year. Murray Co uses a third party warehouse provider to store the manufactured ergometers and approximately one quarter of the other equipment.

 

Historically, Murray Co has only sold to retailers. For the first time this year, Murray Co has made sales directly to consumers, via a new website. The website is directly linked to the finance system, recording sales automatically. Website customers pay on ordering. The website development costs have been capitalised. This initiative was implemented to respond to market demands, as retailer sales have fallen dramatically in the last two years. Some of Murray Co’s retail customers are struggling to pay their outstanding balances. Several of the sales team were made redundant last month as a result of the falling retailer sales.

 

Murray Co is planning to list on the stock exchange next year.

 

Required:

 

Using the information provided, describe SIX audit risks and explain the auditor’s response to each risk in planning the audit of Murray Co.

 

Test your understanding 2

 

Murray Case Study: Analytical procedures

 

Draft Statement of Financial Position as at 31 December 20X4

 

	20X4	20X3
Non-current assets	$000	$000
Property plant and equipment	5,350	4,900
Website development	150	0
	––––––	––––––
	5,500	4,900
Current assets	––––––	––––––
Inventory	2,109	1,300
Trade receivables	2,040	1,050
Cash and cash equivalents	48	38
	–––––	–––––
	4,197	2,388
	–––––	–––––
	9,697	7,288
Equity	–––––	–––––
Share capital (50c shares)	2,100	2,100
Retained earnings	2,959	2,156
	–––––	–––––
	5,059	4,256
Non-current liabilities	–––––	–––––
Long term loan	2,800	1,500
Current liabilities
Provisions	240	195
Trade and other payables	1,400	1,205
Accruals	18	12
Bank overdraft	180	120
	–––––	–––––
	1,838	1,532
	–––––	–––––
	9,697	7,288
	–––––	–––––

 

Draft Statement of Profit or Loss for the year ended 31 December 20X4

 

	20X4	20X3
	$000	$000
Revenue	21,960	19,580
Cost of sales	(18,560)	(17,080)
	––––––	––––––
Gross profit	3,400	2,500
Operating expenses	(2,012)	(2,012)
Finance cost	(340)	(240)
	––––––	––––––
Profit before tax	1,048	248
Taxation	(245)	(24)
	–––––	–––––
Profit for the period	803	224
	–––––	–––––

 

Required:

 

Using the financial information provided, and the information from TYU 1, perform analytical procedures on the draft financial statements of Murray Co and explain the audit risks that arise.

 

 

Test your understanding 3

 

You are an audit senior at JPR Edwards & Co and you are currently planning the audit of Hook Co for the year ending 30 June. Your firm was appointed as auditor in January after a successful tender to provide audit and tax services. JPR Edward & Co were asked to tender after the lead partner, Neisha Selvaratalm, met Hook Co’s CEO, Pete Tucker, at a charity cricket match. Neisha explained that they were unhappy with the previous auditors as Pete Tucker felt their audit didn’t add much value to Hook Co.

 

Hook Co manufacturer’s electrical goods such as MP3 players, smart phones and personal computers for the entertainment market. They do not retail their goods under their own name but manufacture for larger companies with established brands. Their key client, who represents 70% of their revenue, was the market leader in smart phones and MP3 players last year with 60% market share.

 

Hook Co uses a number of suppliers to source components for their products. Most suppliers are based in the UK however Hook Co imports microchips, a key component in all their goods, from a number of suppliers based in San Jose, Costa Rica. They assemble their goods in their one factory in Staines, UK, and package their products for their customers before distribution across the UK.

 

During the year Hook Co started developing applications which can be downloaded onto their smart phones. They have spent $1 million on an application called “snore -o-meter” which allows the users to record the sounds they make while they are asleep. There was a technical difficulty in production which meant the launch of “snore -o-meter” was delayed from the 31 March to its anticipated release on the 31 July.

 

To fund their expansion into Smartphone applications Hook is seeking a listing on the London Stock Exchange in the fourth quarter of the year.

 

Required:

 

Using the information provided, describe FIVE audit risks and explain the auditor’s response to each risk in planning the audit of Hook Co.

 

(10 marks)

 

 

Test your understanding 4

 

Define materiality and explain how the level of materiality is assessed.

 

(5 marks)

 

Test your understanding 5

 

You have received the latest management accounts from your client, Esperence Co, to help with your risk assessment for the forthcoming audit. The management accounts show actual results for the year to date, January to October inclusive. In October Esperence Co received a claim from a customer as a result of a defective product.

 

• Which of the following is an example of an audit risk for Esperence Co?

 

A The client is being sued by a customer for a defective product and if they lose, the compensation awarded is likely to be significant

 

B The client is being sued by a customer for a defective product. The publicity of the case could damage their reputation

 

C The client will have to spend a significant amount of money on improving their quality control procedures to avoid the same defects occurring again

 

D Provisions may be understated if the probable payment resulting from the court case is not recognised as a liability in the financial statements

 

• Which of the following is the correct formula for calculating the payables days ratio using the management accounts of Esperence Co?

 

A Payables/Cost of sales × 304 B Payables/Cost of sales × 365 C Payables/Revenue × 304

 

D  Payables/Revenue × 365

 

• Which of the following is not an analytical procedure?

 

A Calculation of gross profit margin and comparison with prior year

 

B Recalculation of a depreciation charge C Comparison of revenue month by month

D  Comparison of expenditure for current year with prior year

 

• Which of the following is not a ratio? A Gross profit margin

 

B  Acid test

 

C  Inventory turnover

 

D     Revenue growth

 

• You have used the management accounts to calculate the gross profit margin and found it to be higher than the prior year figure. Which of the following would provide a possible explanation?

 

A  Sales prices have been reduced to increase sales volumes

 

B Prices charged by suppliers have increased but the company has not increased sales prices to customers to cover the increased costs

 

C  Closing inventory has been overvalued

 

D Administration expenses have reduced increasing profitability of the company

 

 

Test your understanding 6

 

You are the audit manager responsible for planning the audit of Fremantle Co. The draft financial statements show profit before tax of $3m and total assets of $50m. You have held a planning meeting with the client and have performed preliminary analytical procedures on the draft financial statements. You are currently assessing preliminary materiality for the audit and performing further risk assessment procedures.

 

• Which of the following statements is false in relation to materiality?

 

A  Materiality can be assessed by size or nature

 

B A balance which is omitted from the financial statements cannot be material

 

C  Materiality is a matter of professional judgment for the auditor

 

D There is an inverse relationship between risk and materiality. If audit risk is high, the materiality level set by the audit will be lower

 

• Which of the following procedures are NOT required to be performed in accordance with ISA 315 (Revised) Identifying and Assessing the Risks of Material Misstatement Through Understanding the Entity and its Environment to identify risks of material misstatements?

 

A Inspection B Observation

C External confirmation D Enquiry

 

• Based on the above draft figures, what would be an appropriate level at which to set preliminary materiality?

 

A $150,000 for the statement of profit and loss and $500,000 for the statement of financial position

 

B $500,000 for the statement of profit and loss and $150,000 for the statement of financial position

 

C $1,500 for the statement of profit and loss and $50,000 for the statement of financial position

 

D $50,000 for the statement of profit and loss and $1,500 for the statement of financial position

 

• Performance materiality should be used by the auditor when performing substantive testing during the audit. Which of the following best describes performance materiality?

 

A The maximum amount of misstatement the auditor is willing to accept

 

B The amount at which the auditor deems the misstatement to be trivial

 

C An amount which could influence the economic decisions of the users taken on the basis of the financial statements

 

D An amount set below materiality for the financial statements as a whole to reduce, to an acceptably low level, the risk that misstatements could be material in aggregate

 

• Professional scepticism must be applied by auditors during the audit. Which of the following is NOT an application of professional scepticism?

 

A A critical evaluation of the evidence B An open and questioning mind

C The auditor should not believe anything the client tells them D The auditor must be alert to fraud and error

 

5      summary

		Test your understanding 1
		Audit risks	Auditor’s response
		This is the first year Wimble & Co	More time and resource will
		have audited Murray Co.	need to be devoted to obtaining
		There is a lack of cumulative audit	an understanding of Murray Co
			at the start of the audit. More
		knowledge and experience.
			substantive procedures will
		Detection risk is increased.
			need to be planned and
		Opening balances may be misstated	performed, and larger samples
			tested in order to lower
		as Wimble & Co did not conduct the
			detection risk.
		audit last year.
			Opening balances will need to
			be agreed to the prior year
			signed financial statements. The
			previous auditor could be
			contacted to obtain relevant
			working papers.
		Inventory is stored at a third party	Additional procedures to ensure
		warehouse.	that inventory quantities and
		It may be difficult to obtain sufficient	condition have been confirmed
			for both third party and company
		appropriate evidence over the
			owned locations, e.g.
		quantity and condition of inventory
		held.	•	Attend the inventory count
		There is increased detection risk		(if one is to be performed)
				at the third party
		over completeness, existence and
				warehouses to review the
		valuation of inventory.
				controls in operation.
			•	Inspect any reports
				produced by the auditors
				of third party warehouses
				in relation to the adequacy
				of controls over inventory.
			•	Obtain external
				confirmation from the third
				party regarding the
				quantity and condition of
				the inventory.

 

	Ergometers take up to one week to	The percentage of completion
	manufacture.	basis should be discussed with
	There is likely to be a material work	the client and assessed for
		reasonableness.
	in progress (WIP) inventory balance
	at the year-end. Determining the	The WIP calculation should be
	value and quantity of WIP is	agreed to supporting
	complex.	documentation such as
	There is a risk of misstatement of	purchase invoices for materials
		and timesheets and payroll
	WIP inventory.
		records for labour.
		The overhead calculation should
		be recalculated and reviewed for
		any non-production overheads.
	Murray Co refurbished the assembly	Review a breakdown of the
	line for the ergometers during the	costs and agree to invoices to
	year.	assess the nature of the
	Expenditure incurred may have been	expenditure and if capital agree
	incorrectly capitalised or incorrectly	to inclusion within the asset
		register, and if repairs agree to
	expensed as repairs.
		expense in the statement of
	There is a risk that that non-current
		profit or loss.
	assets are over or understated.
	There is a new website directly	Extended controls testing to be
	linked to the finance system which	performed over the sales cycle,
	records sales automatically.	including the use of test data
	There is increased risk over	where possible.
	completeness of income if the	Detailed testing to be performed
	system fails to record all sales made	over the completeness of
	on the website.	income.
	There is a risk that revenue is
	understated.
	The website development costs	A breakdown of the
	have been capitalised.	development expenditure
	In order to be capitalised, it must	should be reviewed and tested
		in detail to ensure that only
	meet all of the criteria under IAS ®
		projects which meet the
	38 Intangible Assets. Research
		capitalisation criteria are
	costs should be expensed rather
		included as an intangible asset,
	than capitalised.
		with the balance being
	There is a risk that intangible assets
		expensed.
	and profits are overstated.

 

	Retailer sales have fallen	Perform a detailed going
	dramatically in the last two years.	concern review, including:
	If retailer sales continue to fall and	obtain and review the
	direct consumer sales do not	company’s cash flow forecast
	compensate for the loss of retailer	and evaluate the
	revenue, Murray Co may not be able	reasonableness of the
	to continue to operate for the	assumptions used to understand
	foreseeable future.	if management will have
	There is a risk that disclosures of	sufficient cash.
		Review the post year-end order
	material uncertainties relating to
	going concern may be inadequate.	book from retailers and post
		year-end direct consumer sales
		to assess if the revenue figures
		in the cash flow are reasonable.
	Several of the sales team were	Discuss with management the
	made redundant last month as a	progress of the redundancy
	result of the falling retailer sales.	programme and review and
	Under IAS 37 Provisions, Contingent	recalculate the redundancy
	Liabilities and Contingent Assets, a	provision.
	redundancy provision will be
	required for any staff not yet paid at
	the year-end.
	There is a risk of understated
	liabilities.
	Some retail customers are struggling	Extended post year-end cash
	to pay their outstanding balances to	receipts testing to assess
	Murray Co.	valuation.
	The balances may be irrecoverable	Review of the aged receivables
	debts that should be written off.	ledger to identify long
	There is a risk of overstatement of	outstanding debts.
	receivables and understatement of	The allowance for receivables
	the irrecoverable debt allowance.	should be discussed with
		management if it is considered
		inadequate.
	Murray Co is planning to list on the	Maintain professional scepticism
	stock exchange next year.	and be alert to the risks
	There is an increased risk of	identified in order to achieve a
	manipulation of the financial	successful listing.
	statements.	Plan and perform procedures to
	There is a risk of overstatement of	ensure accounting estimates
	assets and profits, and	and judgmental areas are
	understatement of expenses and	reasonable.
	liabilities.

 

Test your understanding 2

 

Audit risks identified using analytical procedures:

 

Revenue has increased	Retailer sales at Murray Co have fallen
by 12%.	dramatically in the last two years. The
	increase in revenue is not consistent with
	this. Although Murray Co has begun selling
	directly to consumers for the first time this
	year, it is unlikely that these sales will have
	compensated for the loss in retailer sales at
	this early stage. In addition, revenue may be
	deliberately overstated by Murray Co in
	order to increase the chances of a
	successful listing. There is a risk that
	revenue is overstated.
Gross profit margin has	The margins for direct consumer sales are
increased from 13%	likely to be higher than retailer sales, which
(2,500/19,580) to 15%	may explain this increase. However, the
(3,400/21,960).	increase could also be caused by
	overstatement of revenue, as explained
	above, or understatement of cost of sales
	due to incomplete recording of costs or
	overvaluation of closing inventory.
Operating expenses has	This is unusual given the increase in
no movement.	revenue and cost of sales. There is a risk
	that the prior year figure has been
	incorrectly presented in the current year
	column.
Net margin has	Net margin has increased at a greater rate
increased from 1.3%	than gross profit margin. Given that this is
(248/19,580) to 4.8%	the first year of direct consumer sales, the
(1,048/21,960).	net margin would not be expected to
	increase significantly as the level of
	operating expenses would normally be
	higher at this early stage. This indicates
	potential overstatement of revenue and
	understatement of operating expenses.
Inventory days has	As sales have increased, this could be
increased from 28	because of an increase in demand and
(1,300/17,080 × 365) to	therefore the need to hold more inventory.
41 (2,109/18,560 × 365)	However, as retailer sales at Murray Co
days.	have fallen dramatically, there is a risk that
	some of the inventory is bespoke, and may
	therefore be obsolete. There is a risk that
	inventory is overstated.

 

		Trade receivables days has	Given that website customers pay on
		increased from 20	ordering, trade receivables days would
		(1,050/19,580 × 365) to 34	be expected to fall. However, some of
		(2,040/21,960 × 365) days.	Murray Co’s retail customers are
			struggling to pay their outstanding
			balances. Trade receivables may be
			overstated, and the allowance for
			doubtful debts understated.
		Trade payables days has	An increase in trade payables days
		increased from 26	could be caused by understatement of
		(1,205/17,080 × 365) to 28	cost of sales. The increase in gross
		(1,400/18,560 × 365) days.	profit margin also highlighted this as a
			potential risk.
		Current ratio has improved	Murray Co appears to be managing its
		from 1.6:1 to 2.3:1.	working capital effectively. However,
		Quick ratio has improved from	given the plans to list on the stock
		0.71: 1 to 1.14:1.	exchange next year, this may be
			indicative of manipulation of the
			financial statements in order to
			increase the chances of a successful
			listing. In addition, Murray Co has
			increased its long and short-term
			finance during the year.

 

Test your understanding 3

 

Audit risks and effect on audit approach

 

Risk and explanation	Effect on audit approach
This is the first year JPR Edwards &	More time should be devoted to
Co have audited Hook Co.	understanding the business at
There may not be as deep an	the start of the audit. More
	substantive procedures may be
understanding of Hook Co’s
	planned to lower detection risk.
business as if they had audited in
previous years.	JPR Edwards & Co will have to
Detection risk is increased.	design specific audit procedures
	to obtain sufficient evidence
Opening balances may be misstated
	regarding opening balances.
as JPR Edwards & Co were not the	This includes agreeing the
auditors last year and cannot rely on
	opening balances to the prior
their own previous work.
	year signed financial statements
	and obtaining relevant working
	papers from the prior year
	auditors.

 

	Hook Co is a manufacturing	Appropriate time should be
	business.	allocated to attending the inventory
	Hook will have a combination of	count and understanding the
		inventory valuation process for work
	raw materials, work in progress
		in progress and finished goods.
	and finished goods in inventory.
		The basis for assessing the
	The calculation and valuation of
		percentage of completion of WIP
	work in progress and finished
		should be discussed with
	goods is subjective.
		management to ensure it is
	There is a risk of overstatement
		reasonable.
	of inventory.	Purchase invoices should be
		inspected to verify cost, payroll
		records and job cards should be
		inspected to verify the labour
		element of WIP and finished goods.
		Overheads included in WIP and
		finished goods should be
		recalculated and reviewed to ensure
		only production overheads are
		included.
	Hook Co manufactures electrical	The aged inventory listing should be
	goods for the entertainment	reviewed for old or obsolete items
	market.	and compared with the allowance
	This is a rapidly changing	made to write the inventory down to
		NRV to ensure the allowance is
	market and goods can become
		adequate.
	obsolete quickly which may
	result in the NRV falling below	If the allowance does not appear
	cost.	adequate, it should be discussed
	There is a risk of overstatement	with management.
	of inventory.
	Their key client represents 70%	Procedures should be designed at
	of their revenue.	the planning stage to allow the
	Hook Co may be over reliant on	auditor to assess the going concern
		risk faced by Hook Co.
	this client which could threaten
	its going concern status if this	Contracts and other
	key client was lost. There is a	correspondence from the key
	risk that disclosures of material	customer should be reviewed to
	uncertainties relating to going	identify any specific risks that the
	concern are inadequate.	client may be lost. Analytical
		procedures should be designed to
		assess the impact on Hook Co’s
		financial position if the contract is
		not renewed.

 

			5
		Hook Co spent $1m on	Enquiries should be made as to how
		developing a new product.	Hook Co identifies whether the
		There is a risk that Hook Co has	criteria for capitalisation have been
			met in accordance with accounting
		capitalised development
			standards.
		expenditure which should have
		been expensed through the	Where amounts have been
		statement of profit or loss as	capitalised further procedures
		research costs.	should be designed, for example, to
		If the application does not meet	assess how Hook Co measures
		the criteria required to classify	whether the project would be
		as development costs they	profitable.
		should be expensed to the
		statement of profit or loss in the
		year they were incurred. There
		is a risk of overstatement of
		intangible assets.
		Hook Co is aiming to list on the	Increased professional scepticism is
		London Stock Exchange this	required when performing the audit.
		year.	Procedures should be planned to
		The directors may have greater	ensure areas of judgment and
		incentive to ‘window dress’ the	estimates exercised by the directors
		accounts to show a more	are reasonable and can be justified.
		favourable position in order to	Special consideration should be
		increase the proceeds
			given to sales cut-off testing.
		generated from flotation. Assets
		and profits may be overstated
		and liabilities understated to
		make the company appear a
		more attractive investment.
		Test your understanding 4
		Materiality is defined as follows:

 

‘Misstatements, including omissions, are considered to be material if they, individually or in aggregate, could reasonably be expected to influence the economic decisions of users taken on the basis of the financial statements.’

 

In assessing the level of materiality there are a number of areas that should be considered. Firstly the auditor must consider both the amount (quantity) and the nature (quality) of any misstatements, or a combination of both. The quantity of the misstatement refers to the relative size of it and the quality refers to an amount that might be low in value but due to its prominence could influence the user’s decision, for example, directors’ transactions.

 

In assessing materiality the auditor must consider that a number of errors each with a low value may when aggregated amount to a material misstatement.

 

The assessment of what is material is ultimately a matter of the auditors’ professional judgment, and it is affected by the auditor’s perception of the financial information needs of users of the financial statements.

 

In calculating materiality the auditor should also consider setting the performance materiality level. This is the amount set by the auditor, below materiality for the financial statements as a whole, and is used for particular transactions, account balances and disclosures.

 

Materiality is often calculated using benchmarks such as 5% of profit before tax or 1% of assets. These values are useful as a starting point for assessing materiality.

 

 

Test your understanding 5

 

• DOptions A, B and C are business risks. An audit risk must be described in terms of a risk of material misstatement (i.e. the impact on the financial statements) or a detection risk (why the auditor may not detect the misstatement).

 

• APayables/Cost of sales × 304. There are 304 days in the period January to October.

 

• BRecalculation is not an analytical procedure. An analytical procedure evaluates relationships between data.

 

• DRevenue growth is a trend rather than a ratio. Acid test is another name for the quick ratio.

 

• CIf closing inventory is overvalued, a larger figure will be deducted from cost of sales and, therefore, cost of sales will be lower and gross profit will be higher.

A and B would both cause gross profit margin to fall. D would have no impact as administrative expenses do not affect gross profit.

 

				5
		Test your understanding 6
		(1)	B	The financial statements can be materially misstated
				by the omission of a balance or disclosure.
		(2)	C	External confirmation is not listed in ISA 315 as a risk
				assessment procedure. It is usually used as a
				substantive procedure.
		(3)	A	Using 5% of PBT and 1% of total assets an
				appropriate level of materiality would be $150,000 for
				the statement of profit or loss and $500,000 for the
				statement of financial position.
		(4)	D	A and B both refer to tolerable misstatement. C is a
				description of materiality for the financial statements
				as a whole.
		(5)	C	Professional scepticism involves being alert to
				possible frauds and errors but does not require
				complete mistrust of the client.