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 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 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 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 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.
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|
|Profit before tax||1,048||248|
|Profit before tax||5%||10%|
- 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.
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
– 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:
‘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.
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.
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.
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.
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.
|Factor||Audit risk||NOT Audit 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|
|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.
|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|
|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|
|should improve||response not an|
|their credit control||auditor response.|
|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.|
|need for these to|
|be written down in|
|Attend the||As written, the|
|inventory count to||response of|
|confirm existence||attending the|
|of the inventory.||inventory count is|
|reworded to say|
|and look out for|
|old or obsolete|
|items that should|
|be written down in|
|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|
|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|
|A company can|
|be profitable but|
|not have sufficient|
|cash available to|
|pay its suppliers|
|ratios can help|
|of going concern|
|would need to be|
|obtain evidence of|
|ability to continue|
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.
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
|Property plant and equipment||5,350||4,900|
|Cash and cash equivalents||48||38|
|Share capital (50c shares)||2,100||2,100|
|Long term loan||2,800||1,500|
|Trade and other payables||1,400||1,205|
Draft Statement of Profit or Loss for the year ended 31 December 20X4
|Cost of sales||(18,560)||(17,080)|
|Profit before tax||1,048||248|
|Profit for the period||803||224|
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.
Using the information provided, describe FIVE audit risks and explain the auditor’s response to each risk in planning the audit of Hook Co.
Test your understanding 4
Define materiality and explain how the level of materiality is assessed.
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
|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|
|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|
|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.|
|confirmation from the third|
|party regarding the|
|quantity and condition of|
|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|
|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|
|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|
|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,|
|with the balance being|
|There is a risk that intangible assets|
|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|
|There is a risk of understated|
|Some retail customers are struggling||Extended post year-end cash|
|to pay their outstanding balances to||receipts testing to assess|
|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|
|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.|
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|
|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|
|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|
|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|
|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|
|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|
|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.|
|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|
|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|
|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|
|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.
|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|
|(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.|