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
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.
management the
need for these to
be written down in
the financial


Attend the As written, the
inventory count to response of
confirm existence attending the
of the inventory. inventory count is
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
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
distorted by
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.




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
––––– –––––




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.


(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
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
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
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
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
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
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


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.
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.


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
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.


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.
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