Chapter 11

Question 1

Define Transaction Based Approach/Vouching based Approach/ Direct verification.

Answer 1

Under this approach no reliance is placed on internal control system of entity to determine level of substantive testing. Auditor may set testing level b/w 50% to 100% of the population.
This approach is used by auditor when entity internal controls are absent/weak or number of transactions are low. e.g: when auditing F/S of a small company.

Question 2

Define system-based approach of auditing.

Answer 2

This approach is used by auditor when auditor decides to rely on internal control system of client to determine level of substantive testing. Following are stages of System-based Approach:
1. Evaluating Internal Control System:
a. Obtain understanding of internal controls.
b. Perform test of controls if controls are assessed strong.
2. Determine the level of substantive testing:
This is based on results of test of controls. If controls are actually operating effectively, reduce level of testing and vice-versa.
However, there may be some inherent limitations of internal control system, so auditor cannot completely rely on controls and will always perform some substantive testing for each area of F/S.

Question 3

Define Risk Based Approach of Auditing.

Answer 3

Under this approach:

1. Auditor obtain understanding of entity and its internal controls.
2. Auditor identifies risk of material misstatement.
   a. at assertion level.
   b. at F/S level.
3. For risk at F/S level, auditor shall follow overall approach.
4. For risk at assertion level, auditor perform test of controls and substantive procedures.
5. Auditor prepares overall audit strategy and audit plan to document these matters.

Question 4

Examples of audit risk and business risk.

Answer 4

All audit risk are business risk but all business risk are not audit risk.

Examples of Audit Risks.

1. Compliance with laws and regulation that relates to F/S.
2. Preparation of F/S.

Examples of Business Risks.

1. Continuous reduction in profits.
2. Compliance with laws and regulation.
3. Preparation of F/S.

Question 5

Define Audit Risk.

Answer 5

Audit risk is the risk that auditor expresses an inappropriate opinion when F/S are materially misstated.
Audit risk is the product of Risk of Material Misstatement and Detection risk.

Question 6

Define Risk of Material misstatement.

Answer 6

The risk that F/S are materially misstated (individually or aggregated) prior to audit. These consist of Inherent risk and Control Risk.

Question 7

Define Inherent Risk with examples and it can be reduced..

Answer 7

The susceptibility of an assertion to a misstatement that could be material (individually or as aggregated) before consideration of any related controls. Inherent Risk may arise from nature of items themselves, or nature of entity/industry.
Example: Risk of theft of precious and portable items, Risk of misstatement in accounts with estimates and judgments.
Inherent Risk cannot be reduced.

Question 8

Define Control Risk with examples and it can be reduced.

Answer 8

The risk that misstatement that could occur in an assertion that could be material (either individually or aggregated) will not be prevented, detected and corrected on a timely basis by the entity’s internal control system.
Example: No physical verification, No Reconciliations, No Authorizations.
Control risk can be reduced by strengthening internal controls.

Question 9

Define Detection Risk with examples and it can be reduced..

Answer 9

The risk that procedures performed by auditor will not detect a misstatement that exists and that could be material (individually or aggregated).
Example: Sampling Risk, Non-sampling Risk.
This can be reduced by more direction, supervision and review and also by increasing the sample size.

Question 10

Define Business Risk

Answer 10

Risk that events or conditions may adversely affect the ability of entity to achieve its objectives.

Question 11

ON which factors auditor shall obtain understanding of entity.

Answer 11

1. Relevant industry, regulatory and other external factors, including AFRF.
2. Nature of the entity and its operations, ownership and MGT structures, types of current and planned investment.
3. Entity’s selection and application of accounting policies, including whether they are consistent with AFRF, and any change in accounting policies is appropriate.
4. Entity’s objectives and strategies and those related business risks that may result in risk of material misstatement in F/S.
5. Evaluation and review of entity’s F/S.

Question 12

Define NPO.

Answer 12

NPO does not work to make profit for its shareholders. Its objectives are to provide services to society as a whole or to a group in society. Examples are Charites, Societies, Clubs and Govt. Organizations.

Question 13

Define Charity.

Answer 13

Charity is an organization which raises funds from general public and spend its funds on defined beneficiaries in accordance with its objectives.

Question 14

What is an audit approach for a NPO.

Answer 14

1. Audit approach in planning.
2. Audit approach in Risk Assessment.
3. Audit approach in Assessing Internal Controls.
4. Audit approach in Obtaining Evidence.
5. Audit approach in forming opinion.

Question 15

Explain Audit approach in planning stage a NPO

Answer 15

Auditor shall consider:

1. Environment in which organization operates.
2. Objective and scope of work.
3. Local regulations applicable on NPO.
4. Form and content of F/S.
5. Key audit areas.(Cash).

Question 16

Audit approach in Assessing Internal Control of a NPO.

Answer 16

Key areas of internal controls include:

1. Controls over incomes.
2. Controls over expenditure.
3. Controls over recording of income and expenditure.

However, control department of NPO is likely to be weak because:

1. Lack of segregation of duties as staff is limited.
2. Volunteer staff which may not be well qualified or experienced to develop good control system.
3. Lack of authorizations due to lack of involvement of trustee.
4. Not internal audit department of NPO.

Question 17

Audit approach in obtaining evidence in audit of NPO.

Answer 17

1. Substantive testing approach should be used because of weak internal controls and lack of control activities.
2. Analytical procedures will be important to ensure reasonableness of reported figures.
3. Key areas include:
   a. Possibility of misuse of funds
   b. Completeness of income, expenses, assets and liabilities.

Question 18

Audit approach in reporting phase of an audit of NPO.

Answer 18

If audit of NPO is required by law, the report prescribed by law may be applicable. If audit is conducted voluntarily, than report prescribed by ISAs may be used with modification according to agreed scope and objective of audit.

Question 19

What inherent risk are associated with incomes of NPO.

Answer 19

Risk Factor. Explanation. Effect on audit approach.

1. If income of charity. Donation income is Audit report may need
   Is derived wholly unpredictable. It may. to be modified because
   from donations. Fall in poor economic. going concern assumption
   causing going concern. is affected by uncertainty
   issue. of future incomes.
2. If cash is collected. It is difficult to ensure Audit opinion may need to
   by volunteers from. completeness of income. be modified because of
   various locations. because volunteers lack of evidence to
   may be inexperienced. ensure completeness of
   Further, donations may be. income.
   stolen by volunteers.

Question 20

What inherent risks are associated with expenses of NPO.

Answer 20

Risk Factor. Explanation. Effect on audit approach.

1. If constitution of There is the risk that Expenditures will have to
   charity specifies expenditures can be be carefully reviewed to
   how the income is incurred for objects ensure that:
   to be spent. outside the constitution. a. funds are not miused.
   of charity b. expenditure are not
   ultra-varies the objectives
   of charity.
2. If there are There is a risk that Auditor will check:
   specific instructions. donations may not be a. Specific donation is
   about utilization of. recorded appropriately. recorded as liability.
   donations. or may not be spent as b. Specific donation is
   per instructions of donor. spent as per instructions
   of donor.
3. If constitution of There is a risk that Auditor will check whether
   charity requires that admin expenses can this limit has exceeded.
   admin expenses exceed this limit and Auditor will also check
   cannot exceed a may be miscalssified areas if there are unusual
   certain percentage. by MGT. increase in other expenses
   of income. as a possibility of
   Misclassification of admin
   expenses