Chapter 3 - Process of assurance: Planning the assignment

Question 1

What is the objective of planning an audit, according to ISA 300?

Answer 1

The objective is to plan the audit so it can be performed in an effective (correct opinion) and efficient (make a profit) manner, ensuring that significant areas are properly addressed and managed.

Question 2

What are the main objectives of audit planning? (6)

Answer 2

1. Ensure attention to important areas. Materiality + Risk
2. Identify potential problems and resolve them on a timely basis
3. Ensure that the audit is properly organised and managed
4. Assign work to engagement team members properly
5. Facilitate direction and supervision of engagement team members
6. Facilitate review of work

Question 3

What is an audit strategy?

Answer 3

BIG PICTURE

An audit strategy outlines the scope, timing, and direction of the audit, guiding the development of the audit plan and addressing broad objectives.

Question 4

What does an audit plan include?

Answer 4

DETAIL

The audit plan is a detailed guide specifying the nature, timing, and extent of audit procedures to be carried out by the team to gather sufficient and appropriate audit evidence.

Question 5

Audit Strategy MR BICEP

Answer 5

Materiality + Risk
Resources
Business Understanding
Internal
Control
Environment
People

Materiality + Risk - Basis for setting materiality and risk assessment
Resources - Team members involved, budgeted hours, timing and fee
Business Understanding - Locations, structure, management’s integrity.
Internal
Control- Understanding client accounting policy choices & Understand the reliability of clients’ systems for detecting and preventing accounting fraud and error
Environment - Industry and economic conditions.
People

Question 6

What is the importance of understanding the entity in audit planning?

Answer 6

Understanding the entity helps auditors identify potential risks, business factors, and relevant internal controls, which shape the approach and focus of the audit.

ISA 315 (UK and Ireland) Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and its Environment states that ‘the objective of the auditor is to identify and assess the risks of material misstatement, whether due to fraud or error, at the financial statement and assertion levels, through understanding the entity and its environment.

Question 7

When we are understanding the entity
a. Why do we do this? (3)
b. How is it done? (4)
c. What’s involved? (5)

Answer 7

a.
Identify and assess the rules
Identify and assess the audit approach
Focus attention and effort on appropriate risks

b.
AEIO
Analytical Procedures - MUST be done in planning stage
Enquires - MUST ask employees + directors
Inspection
Observation

c.
Look at:
- Nature of the entity e.g. what type of business, how does it make revenue, what expenses does it have
- Objectives and Strategies e.g. profit, brand awareness, market share, innovation, copyright
- Entity’s financial performance e.g. profit making, share price
- Internal control w.g. security, stock count, IDs , cash accounting, restricted access
- Industry, regulatory & external factors e.g. new laws, geo location, any competitors

Question 8

What is professional skepticism, and why is it essential in auditing?

Answer 8

Professional skepticism is a questioning mind and critical assessment of evidence, helping auditors remain alert to errors or fraud during the audit process.

Professional scepticism does not mean that auditors should disbelieve everything they are told; however, they must have a questioning attitude.

Question 9

When are analytical procedures used?

Answer 9

Analytical procedures MUST be used at the risk assessment stage as part of Understanding the Entity and its Environment - when we plan the audit.

Question 10

Define analytical procedures in audit planning?

Answer 10

Analytical procedures involve evaluating financial and non-financial information relationships to identify inconsistencies or unusual trends that may indicate risk areas

Compare data to
 Prior Periods
 Budgets
 Ratio Analysis (see below)
 Non-financial information
 Industry information

Question 11

What are the 5 types of key ratios used in analytical procedures?

Answer 11

1. Performance
   - Return on capital employed
   - Gross profit margin
   - COS %
   - Operating cost %
   - Operating profit margin
2. Liquidity
   - Current ratio
   - Quick ratio
3. Long term solvency
   - Gearing
   - Interest cover
4. Efficiency
   - Net asset turnover
5. Working Capital
   - Inventory period
   - Trade receivable period
   - Trade payable period

Question 12

Analytical Procedure Ratio - Performance - Return on capital employed

Answer 12

Return on capital employed (ROCE) = Profit before interest and tax/ Capital employed

Capital employed = TALCL OR Equity (sc+sp+re) + NCL
TALCL = total assets LESS current liabilities

• Measures how much profit is generated for every £ of assets employed
• Indicates how efficiently the company uses its assets

Want this to be HIGH (depends on industry, age of assets, whether co revalues its PPE etc) e.g. Unilever (manufacture) ~20% but PWC (Services) ~50%

Question 13

Analytical Procedure Ratio - Performance - Gross profit margin

Answer 13

Gross Profit Margin = Gross Profit / Revenue

Want this to be HIGH

• Usually does not change dramatically from one period to the next, unless the company changes its sales mix (sales mix e.g. new product introduced which has a higher profit margin)
• Increased margin may be due to decreasing costs or increased sales prices
  -Changes could result from Improved / reduced purchasing power (economies of scale) e.g. f you buy more from your supplier they will likely give you a better deal.
• And increase in GP% could be due to overstated revenue, understated purchases or overstated inventories

Question 14

Analytical Procedure Ratio - Performance - COS %

Answer 14

COS % = Cost of sales (Op Inv + Purchases - Cl Inv) / Revenue
How well business is controlling its purchase prices or production costs (if manufacturer)

Want this to be LOW

Question 15

Analytical Procedure Ratio - Performance - Operating cost %

Answer 15

Operating cost % = Operating costs (Distribution + Admin Expenses)/ Revenue

How well business is controlling its distribution and administrative expenses
Want this to be LOW

Question 16

Analytical Procedure Ratio - Performance - Operating profit margin

Answer 16

Operating Profit Margin = Profit before interest and tax (PBIT) / Revenue

Want this to be HIGH

• Can reflect how efficiently a business is being run, i.e. through controlled overheads
• How well business is operating its core activities and controlling its costs
• A sharp increase or decrease in this ratio is probably due to changes in administrative expenses, e.g. bad debts, restructuring costs, salary increases.
• Note: you need to be careful when calculating PBIT. Most statements of profit or loss only give PBT so you will need to add back the interest charge to arrive at PBIT.

Question 17

Analytical Procedure Ratio - Liquidity - Current ratio

Answer 17

Current ratio = Current assets / Current liabilities

• CA = (Inventory + Receivables + Cash + Prepayments)
• CL = (Payables + Overdraft)
• How easily business can afford to pay its current liabilities out of its current assets
• Measures how easily a company can meet its current obligations.
• Less than 1 means CL > CA and could be a cause for concern, e.g. how will company pay its creditors?
• “Correct” level depends on the industry:
  – Too high indicates too much cash tied up in working capital
  – Too low and we cannot meet obligations as they fall due

Ideally ≥ 1 but depends on industry (e.g. supermarkets typically < 1)
Too low = liquidity probs; Too high = holding costs/poor return on assets

Question 18

Analytical Procedure Ratio - Liquidity - Quick ratio (aka Acid Test)

Answer 18

Quick ratio = Current assets – Inventory / Current liabilities

• How easily business can afford to pay its current liabilities out of its most liquid current assets
• In times of crisis, businesses struggle to sell inventory quickly. What can be turned into cash quickly.
• Quick ratio (or acid test) sometimes seen as better test of liquidity as excludes inventory.
• Value depends on industry

Question 19

Analytical Procedure Ratio - Long term solvency - Gearing

Answer 19

Gearing ratio = Net debt / Equity

Amount of lending/investment that is tied up in debt as a proportion of the investment from the shareholders (equity)
Net debt = Loan - Cash = Risky Investment
Equity = SC + SP + RE + Other Reserves = Unrisky Investment

• Debt is riskier than equity due to interest having to be paid and risk assets will be seized if repayments are not made
• Composition of business’s long-term finance (money borrowed from lenders versus money sourced from shareholders)
• Can be increased/decreased by: significant asset purchases; repayment of debt, issue of new debt
• Loan agreements (covenants) may require a company not to exceed a particular level of gearing.
• Higher the number the worser the company is to invest in

Too high - risk company won’t be able to service its finance (pay interest & repay capital)
Too low - not taking advantage of cheaper debt finance (interest is tax-deductible & lower risk to investor

Question 20

Analytical Procedure Ratio - Long term solvency - Interest cover

Answer 20

Interest cover = Profit before interest and tax (PBIT) / Interest payable expense

• Profit before interest and tax (PBIT) = Operating cost
• Interest payable expense = Finance Costs
• This ratio shows how many times the interest expense can be covered by profits. In simple terms, the higher this figure is, the easier the company will find it to pay its interest expense.

Ideally ≥ 1 (bank loan covenants typically require interest cover of around 2.5 - 3.5)

Question 21

Analytical Procedure Ratio - Efficiency - Net asset turnover

Answer 21

Net asset turnover = Revenue / Capital employed

Capital employed = TALCL OR Equity (sc+sp+re) + NCL
TALCL = total assets LESS current liabilities

• How efficiently business uses its long-term finance to generate revenue
• Measures how much sales revenue is generated for every £ of assets employed
• A significant decrease can be caused by new assets being purchased close to the year end
• An increase could be caused by the purchase of more efficient assets
• Want this to be HIGH (depends on industry, age of assets, whether co revalues its PPE etc)

Question 22

Analytical Procedure Ratio - Working Capital - Inventory period

Answer 22

Inventory Days = (Inventory/COS) x 365 days

• Shows how long a business takes to sell its inventory
• If increasing there could be a risk of obsolete inventory - we would need to write down cost to NRV

Too low - risk running out of inventory
Too high - high inventory holding costs

Question 23

Analytical Procedure Ratio - Working Capital - Trade receivable period

Answer 23

Receivables collection period = (Trade receivables / Revenue) × 365 days

• Shows how quickly customers settle their debts
• Depends on credit policy and credit controls
• Increase may be indicative of recognition of fake sales/trade receivable
• Compare to business’s credit terms
  
  • if considerably higher than credit terms = risk of bad debt
  • if lower = great, efficient, cash flow

Question 24

Analytical Procedure Ratio - Working Capital - Trade payable period

Answer 24

Payables Payment Period = (Trade payables / Purchases (or COS)) × 365 days

• Shows how quickly a business pays its suppliers
• A significant decrease could be indicative of unrecorded credit purchases at the year end

Company to supplier’s credit terms - want to take advantage of full credit term (free credit) But if too high, risk of losing supplier’s goodwill & supplier could refuse to supply

Question 25

Working capital cycle

Answer 25

Working capital cycle = Inventory period + Receivables period - Payables period

Inventory period: Buy inventory to sell inventory
Receivables period: Sell inventory to customer pays
Payables period: Buy inventory to pay suppliers

No. of days of finance required to fund working capital requirement
Want to keep low but depends on industry

Question 26

What is materiality, and how is it determined in auditing?

Answer 26

Materiality is the level at which an omission (left out) or misstatement (e.g. wrong heading/no.) in financial statements could influence users’ economic decisions. It’s typically calculated based on percentages of RAP - revenue, total assets, or PBT

Question 27

What does ISA 320 (UK and Ireland) say about the use of materiality in auditing?

Answer 27

ISA 320 states that materiality and audit risk should be considered throughout the audit, especially in identifying risks, determining procedures, and evaluating uncorrected misstatements.

Question 28

Materiality states that ‘materiality and audit risk are considered throughout the audit, in particular, when: (3)

Answer 28

Materiality states that ‘materiality and audit risk are considered throughout the audit, in particular, when:
 Identifying and assessing the risks of material misstatement - giving an opinion that we have reasonable assurance
 Determining the nature, timing and extent of further audit procedures - bigger the number the more work
 Evaluating the effect of uncorrected misstatements = do the small mistakes add up to be material

Question 29

How does materiality affect the auditor’s opinion on reasonable assurance?

Answer 29

Materiality helps in assessing whether there are material misstatements, thus affecting the auditor’s opinion on whether there is reasonable assurance that the financial statements are free of material misstatement.

Question 30

How does materiality influence the nature, timing, and extent of further audit procedures?

Answer 30

Higher materiality allows for less intensive procedures, while lower materiality requires more detailed testing to ensure smaller misstatements are detected.

Question 31

Why do auditors evaluate the effect of uncorrected misstatements?

Answer 31

Auditors evaluate if small misstatements, when combined, reach a material threshold, impacting the accuracy of the financial statements.

Question 32

How do auditors determine preliminary materiality levels?

Answer 32

Auditors calculate a range of values, using an average or weighted average of these figures as the preliminary materiality level, though methods may vary by firm.

Question 33

Does materiality consider qualitative as well as quantitative factors?

Answer 33

Yes, materiality includes both quantitative aspects (such as amounts) and qualitative aspects, like transactions involving directors, which are material by nature.

Question 34

What is the relationship between risk and materiality in auditing?

Answer 34

High risk requires a lower materiality threshold, meaning more detailed testing, while low risk allows for a higher materiality threshold, focusing only on larger transactions.

Question 35

Provide an example of calculating materiality for a low-risk client with revenue of £1,000,000. Revenue materiality is set at 1%.

Answer 35

If revenue materiality is set at 1%, then the materiality level is £10,000. Transactions above £10,000 are investigated in detail, while smaller amounts can be reviewed quickly in the nominal or general ledger.

Question 36

Why is materiality considered a matter of judgment in auditing?

Answer 36

Materiality is based on the auditor’s professional judgment, considering factors like client risk, the nature of transactions, and potential impact on user decisions.

Question 37

RAP - Materiality

Answer 37

Revenue 0.5-1%
Total Assets 1-2%
Profit before tax 5-10%

Question 38

What is performance materiality?

Answer 38

Performance materiality is set below overall materiality to reduce the risk of uncorrected misstatements exceeding materiality, guiding the scope of audit testing

‘haircut’ to planning materiality so if planning was 100% = 10,000. performance is 50-75% = 5,000 to 7,500

Question 39

How often should materiality levels be reviewed during an audit?

Answer 39

Materiality should be reviewed continuously, especially if there are significant changes in the draft accounts or external factors affecting risk.

-Draft accounts are altered (due to material error and so on) and therefore overall materiality changes. RAP might have changed
- External factors may cause changes in risk estimates. e.g. acquisition target therefore materiality is lower

Question 40

Define audit risk (1) and its components (3)

Answer 40

Audit risk is the risk that an auditor may issue an incorrect opinion on materially misstated financial statements. It includes inherent risk, control risk, and detection risk.

Question 41

If an auditor makes a wrong judgement what can happen?

Answer 41

Sued
Fined
Barred

By Financial Reporting Council

Question 42

What is inherent risk in auditing?

Answer 42

Inherent risk is the susceptibility of an assertion (like a transaction, account balance, or disclosure) to a material misstatement, either individually or in combination with others, before considering any related controls.

Nobody can impact this.

Question 43

Why is inherent risk considered “risky by nature”?

Answer 43

Inherent risk is intrinsic to certain transactions or situations and cannot be directly altered; it simply exists due to the nature of the business or circumstances.

Question 44

Name a few factors that increase the susceptibility to inherent risk (7)

Answer 44

Cash-based business
Operating in a regulated industry
Management under pressure
Company being sold or raising finance
Significant estimates by management - e.g. depreciation, warranty, provisions
High remuneration of management
Risk of non-compliance with accounting standards

Question 45

How does a cash-based business contribute to inherent risk?

Answer 45

Cash transactions are more prone to misstatement due to their nature, as they are difficult to trace and may be more susceptible to theft or fraud.

Question 46

Why does a regulated industry carry higher inherent risk?

Answer 46

Regulated industries must comply with strict rules, increasing the chance of misstatements if compliance is not met or regulations are complex.

Question 47

How can management under pressure affect inherent risk?

Answer 47

Pressure on management, such as financial targets or performance expectations, may lead to a higher risk of misstatement due to potential bias or manipulation.

Question 48

Why does a company trying to raise finance face increased inherent risk?

Answer 48

When a company seeks financing, there may be pressure to present favorable financial statements, potentially leading to biased estimates or aggressive accounting choices.

Question 49

How does reliance on estimates by management increase inherent risk?

Answer 49

Estimates involve judgment and are inherently uncertain, increasing the likelihood of material misstatements if the estimates are incorrect or overly optimistic.

Question 50

Why does high remuneration of management contribute to inherent risk?

Answer 50

High remuneration, often linked to performance, may incentivise management to manipulate results to meet targets, increasing risk of misstatements.

Question 51

What role does non-compliance with accounting standards play in inherent risk?

Answer 51

Failing to comply with accounting standards can lead to misstatements, as these standards are designed to ensure accurate and fair financial reporting.

Question 52

What is control risk in auditing?

Answer 52

Control risk is the risk that a material misstatement will not be prevented, detected, or corrected on a timely basis by the entity’s internal controls.

Question 53

Who can influence control risk?

Answer 53

Control risk can be impacted by the client, company, or management, as they implement and oversee internal controls.

Question 54

What is the primary purpose of control risk processes?

Answer 54

Control risk processes and procedures are designed to prevent or detect fraud or errors within the entity.

Question 55

Give an example of a situation that might increase control risk

Answer 55

An increase in control risk could occur if internal controls fail or if they are not consistently enforced, allowing for potential misstatements to go undetected.

Question 56

Name examples of factors within the control environment that affect control risk (3)

Answer 56

1. Integrity and competence of employees - should ask for references
2. Active role of management in oversight
3. Existence and enforcement of policies and procedures

Question 57

How does employee integrity and competence impact control risk?

Answer 57

Higher integrity and competence in employees can reduce control risk, as they are more likely to follow procedures and detect misstatements.

Question 58

List some control activities that help reduce control risk (6)
PARIS V

Answer 58

Physical or logical controls e.g. security
Authorisation procedures e.g. journals/time sheets
Reconciliations e.g. bank
Information processing and general IT controls e.g. passwords
Segregation of duties
Verifications

Question 59

PARIS V

Answer 59

Physical or logical controls e.g. security
Authorisation procedures e.g. journals/time sheets
Reconciliations e.g. bank
Information processing and general IT controls e.g. passwords
Segregation of duties
Verifications

Question 60

Paris v
Describe “Physical or Logical Controls” as a control activity

Answer 60

This involves physical security (like locking assets) and logical checks (like sequential numbering of documents) to protect company assets.

Question 61

pAris v
What is the purpose of authorisation and approval controls?

Answer 61

Authorisation ensures only approved transactions occur, with appropriate management oversight (e.g., approval of overtime or purchase orders).

Question 62

paRis v
How do reconciliations help manage control risk?

Answer 62

Reconciliations compare internal records to external records, identifying and correcting discrepancies that might otherwise go undetected.
Comparing two or more data elements

Question 63

parIs v
What role do information processing and IT controls play in managing control risk?

Answer 63

These controls ensure data accuracy and integrity, preventing or identifying errors or unauthorised transactions within automated systems.

Question 64

pariS v
Why is segregation of duties important in reducing control risk?

Answer 64

Segregation of duties prevents one individual from controlling all aspects of a transaction, reducing the chance of undetected fraud or error.
It ensures different individuals handle authorising, processing, and maintaining custody of assets to reduce the risk of errors and fraud.

Question 65

paris V
Define “Verifications” as a type of control activity

Answer 65

Verifications involve comparing an item with a policy, such as monthly expenditure against a budget, and investigating any differences.

Question 66

What is detection risk in auditing?

Answer 66

Detection risk is the risk that the auditor’s procedures will fail to detect a material misstatement that exists in the financial statements, either individually or when aggregated with other misstatements.

Question 67

Who impacts detection risk?

Answer 67

Auditors can impact detection risk through the effectiveness of their audit procedures and the rigor applied in the audit.

Question 68

What are the two main components of detection risk?

Answer 68

1. Sampling Risk
2. Non-Sampling Risk

Question 69

What is sampling risk in the context of detection risk?

Answer 69

Sampling risk is the risk that the sample selected by the auditor is not representative of the entire population, leading to an incorrect conclusion because not all transactions were tested.

Question 70

Why does sampling risk arise in auditing?

Answer 70

Sampling risk arises because the auditor does not test 100% of transactions, so there’s a chance that important misstatements may be missed.

Question 71

What is non-sampling risk in detection risk?

Answer 71

Non-sampling risk is the risk that a material misstatement goes undetected due to factors unrelated to sampling, such as auditor inexperience, lack of time, or poor audit approach.

Question 72

List some examples that can increase non-sampling risk (4)

Answer 72

Recent appointment of the auditor
A rushed audit job
Poor audit approach
Lack of objectivity or professional skepticism

Question 73

How can auditors reduce non-sampling risk?

Answer 73

Auditors can reduce non-sampling risk by ensuring the audit team is experienced, properly supervised, follows a well-planned approach, and applies professional skepticism throughout the audit.

Question 74

What impact does detection risk have on audit risk?

Answer 74

High detection risk increases the overall audit risk, as it raises the chance that material misstatements could go undetected, affecting the reliability of the audit opinion.

Question 75

How do sampling and non-sampling risks contribute to detection risk?

Answer 75

Sampling risk arises from the sample not representing the entire population, while non-sampling risk is due to procedural or human factors that may cause auditors to overlook material misstatements.

Question 76

How do auditors use the audit risk model in planning?

Answer 76

The audit risk model (Audit Risk = Inherent Risk × Control Risk × Detection Risk) helps auditors design procedures to keep overall audit risk at an acceptable level.

Question 77

What type of audit risk is this - the organisation has few employees in the accounts department

Answer 77

Detection risk

Question 78

What type of audit risk is this - the organisation is highly connected with the building trade

Answer 78

Inherent risk

Question 79

What type of audit risk is this - the assurance firm may do insufficient work to detect material errors

Answer 79

Control risk

Question 80

What type of audit risk is this - the organisation has few employees in the accounts department financial statements contain a number of estimates

Answer 80

Inherent risk

Question 81

What steps are involved in identifying and assessing risks of material misstatement? (4)

Answer 81

1. Identify risks by understanding the entity.
2. Assess risks to determine what could go wrong at the assertion level.
3. Evaluate if risks are significant.
4. Design procedures to address identified risks

Question 82

What is the difference between fraud and error in financial statements?

Answer 82

Fraud is an intentional act to misstate financial statements, while error is an unintentional misstatement.

intentional = on purpose/deliberate
unintentional= accidental/mistake

Question 83

What are the two main types of fraud that cause material misstatement in financial statements?

Answer 83

1. Fraudulent Financial Reporting
2. Misappropriation of Assets

Question 84

What is fraudulent financial reporting?

Answer 84

Fraudulent financial reporting involves intentional misstatements or omissions in financial statements to deceive users.

Question 85

What is misappropriation of assets?

Answer 85

Misappropriation of assets involves the theft or misuse of the entity’s assets, such as cash, inventory, or other resources.

Question 86

What are management’s responsibilities in relation to fraud?

Answer 86

Management is responsible for preventing (STOP) and detecting (SPOT) fraud by implementing internal controls and promoting a culture of honesty and ethical behavior.

Question 87

What are the auditor’s responsibilities regarding fraud?
What are the auditor’s specific objectives in relation to fraud? (4)

Answer 87

Auditors must obtain reasonable assurance that financial statements are free from material misstatement due to fraud.

What are the auditor’s specific objectives in relation to fraud?iDENTIFY and assess risks of material misstatement due to fraud.
DESIGN and implement appropriate tests to address these risks.
RESPOND appropriately to any actual or suspected fraud identified.
MUST REPORT to management unless they’re involved then you MAY tell shareholder or any regulators

Question 88

What are the auditor’s specific objectives in relation to fraud? (4)

Answer 88

iDENTIFY and assess risks of material misstatement due to fraud.
DESIGN and implement appropriate tests to address these risks.
RESPOND appropriately to any actual or suspected fraud identified.
MUST REPORT to management unless they’re involved then you MAY tell shareholder or any regulators

Question 89

With respect to ISA (UK) 315 (Revised), Identifying and Assessing the Risks of Material Misstatement, which three of the following procedures must be used in understanding the entity and its environment?
A Inquiries of management and other appropriate individuals within the entity
B Inquiries of third parties
C Analytical procedures
D Observation and inspection

Answer 89

A Inquiries of management and other appropriate individuals within the entity
C Analytical procedures
D Observation and inspection
The standard states that inquiries of third parties may be carried out if useful, but lists options A, C and D as procedures that shall be carried out.

Question 90

Which three of the following constitute analytical procedures?
A Consideration of comparable information for prior periods
B Consideration of relationships between elements of financial information that are expected to conform to a predicted pattern
C Consideration of whether a balance has been calculated correctly
D Consideration of similar industry information

Answer 90

A Consideration of comparable information for prior periods
B Consideration of relationships between elements of financial information that are expected to conform to a predicted pattern
D Consideration of similar industry information
The answer is not consideration of whether a balance has been correctly calculated, as this will require a procedure of recalculation as opposed to an analytical procedure.

Question 91

4 Which three of the following are auditors helped to decide by setting a preliminary materiality threshold?
A What audit staff to assign to the audit
B How many items to examine
C Whether to use sampling
D What level of misstatement is likely to lead to the auditor not being able to give an unmodified opinion

Answer 91

B How many items to examine
C Whether to use sampling
D What level of misstatement is likely to lead to the auditor not being able to give an unmodified opinion
What audit staff to assign to the audit would depend more on the risks associated with the engagement than the level of materiality.

Question 92

8 Audit risk can be split into three components: inherent risk, control risk and detection risk. For each of the following examples, select the type of risk illustrated.
The organisation is seeking to raise finance for a new venture.
A Inherent
B Control
C Detection
The organisation has a number of estimates in its financial statements.
D Inherent
E Control
F Detection

Answer 92

Correct answer(s): A Inherent
This scenario increases the susceptibility of the financial statements to material fraud and error, and the fact the organisation is seeking to raise finance for a new venture represents a risk at the company level.
Correct answer(s): D Inherent
This scenario increases the susceptibility of the financial statements to material fraud and error, the estimates present a risk at the individual account level where those estimates are found.

Question 93

9 Audit risk can be split into three components: inherent risk, control risk and detection risk. For each of the following examples, select the type of risk illustrated.
The organisation has a high turnover of staff in the accounts department.
A Inherent
B Control
C Detection
The auditor will be using samples in testing.
D Inherent
E Control
F Detection

Answer 93

Correct answer(s): B Control
High staff turnover increases the risk that the internal controls in place will not be effective.
Correct answer(s):
F Detection
The use of samples in testing represents a sampling risk: that the sample tested will not represent the population as a whole. Sampling risk is part of detection risk.

Question 94

12 Audit risk can be split into three components: inherent risk, control risk and detection risk. For each of the following examples, select the type of risk illustrated.
Senior management regularly overrides the system of controls.
A Inherent
B Control
C Detection
Directors’ pay is related to company profitability.
D Inherent
E Control
F Detection

Answer 94

B Control
The existence of management override increases control risk as controls may be ignored leading to an increased risk of material fraud or error.

D Inherent
Profit-related pay may motivate the directors to distort the financial information, so constituting an inherent risk.

Question 95

What is detection risk, and why does it influence materiality and sample size?

Answer 95

Detection risk is the risk that the auditor’s procedures will not detect a material misstatement. To manage this risk:
- Materiality is lowered to focus on smaller errors.
- Sample sizes are increased to ensure thorough testing.

Question 96

14 As part of their overall risk assessment an auditor has concluded that detection risk must be set low. For each of the following, select the appropriate consequence of this.

Materiality
A Higher
B Lower

Sample sizes
C Bigger
D Smaller

Answer 96

Correct answer(s): B Lower
Correct answer(s): C Bigger
If detection risk is required to be low this means that the auditor must have a higher expectation of identifying errors and misstatements. Materiality is lower as the financial statements are more sensitive and sample sizes are increased so that more work is performed

Question 97

15 For each of the following situations, select the most appropriate approach which should be used by the assurance firm.
The audit of a new client, recently started up, with few employees in its accounting department
A Tests of control only
B Substantive procedures only
C A mix of tests of control and substantive procedures

The audit of a long-standing client with a sophisticated IT system and an internal audit department
D Tests of control only
E Substantive procedures only
F A mix of tests of control and substantive procedure

Answer 97

Correct answer(s):
B Substantive procedures only
Substantive procedures only – a new client with few employees implies a lack of segregation of duties and hence high control risk. Therefore, reliance should not be placed on the system of internal control. Audit evidence should be gathered using substantive procedures.

Correct answer(s):
F A mix of tests of control and substantive procedures
A mix of tests of control and substantive procedures may be used for the audit of a long-standing client with a sophisticated IT system and an internal audit department as it will be possible to rely on internal controls and then perform reduced substantive procedures. Note that some substantive procedures must always be performed due to the inherent limitations of any system of internal control.

Question 98

16 As part of your analytical procedures on the financial statements of Dreamy Desserts Ltd you have identified that the gross profit margin has fallen from 27% to 24%.
Which two of the following could be a valid explanation for this decrease?
A Unusually high sales at the end of the year resulted in lower levels of closing inventory as
compared to the previous year
B Increased competition resulted in sales prices being cut
C A bank overdraft resulted in a higher interest expense than in previous years
D There was a significant change in the mix of products sold

Answer 98

B Increased competition resulted in sales prices being cut D There was a significant change in the mix of products sold
If sales prices are cut but costs remain the same gross profit margins will fall. If the company sells a greater proportion of goods with a lower margin than in previous years the overall margin will be reduced. Increased levels of sales (and therefore lower closing inventory) will not affect gross profit margins provided selling prices are maintained. Interest expense is not deducted in arriving at gross profit, therefore it can have no effect on gross profit margins.

Question 99

If inventory is the largest balance on the statement of financial position is Inherent risk higher than normal or lower than normal

Answer 99

Inherent risk higher than normal
Inventory is by its nature more inherently risky as it is susceptible to theft, omission and misstatement.

Question 100

18 For each of the following statements, select whether they are true or false in respect of the concept of materiality.
Materiality depends only on the monetary amount of an item.
A True
B False
Materiality may depend on either the nature of an item or its monetary amount.
C True
D False
Materiality is a matter of professional judgement.
E True
F False

Answer 100

Correct answer(s):
B False
Materiality can be both quantitative and qualitative.
Correct answer(s):
C True
Materiality may depend on either the nature of an item or its monetary amount.
Correct answer(s):
E True
Materiality is determined by the external auditor and they will use their professional judgement in
setting a level of materiality which best addresses the audit risk.

Question 101

21 Deteriora Ltd’s quick ratio has fallen from 1.9:1 to 1.6:1. Which one of the following might help to explain this decline?
A The allowance for receivables has been reduced
B Credit control has been poor
C The entity has purchased a property for cash
D Inventory levels have fallen

Answer 101

C The entity has purchased a property for cash
If the entity has purchased a property for cash, this would reduce current assets without any corresponding reduction in current liabilities.

Question 102

22 An electrical store and a cake shop have the same mark-up on cost. However, the gross profit margin of the electrical store is significantly higher than that of the cake shop.
Which one of the following is a possible reason for this?
A The cake shop’s revenue is increasing, while that of the electrical shop is decreasing.
B The cake shop has a higher level of wastage of inventory than the electrical store.
C The electrical shop takes advantage of trade discounts for bulk buying.
D The cake shop has a higher turnover of inventory than the electrical store.

Answer 102

B The cake shop has a higher level of wastage of inventory than the electrical store.
If the cake shop has a higher level of wastage of inventory than the electrical shop, then the cost of wasted inventory will be treated as an expense in cost of sales. This will reduce its cost of sales independently of the mark-up applied. Cost of sales will therefore be high in relation to revenue, so the cake shop’s gross margin will be lower.

Question 103

23 Thatch plc’s current ratio this year is 1.33:1 compared with 1.25:1 last year.
Which two of the following would be possible explanations of this?
A Thatch paid its payables earlier than usual out of a bank overdraft
B Thatch made an unusually large sale immediately before the year end
C Thatch made an unusually large purchase of goods for cash immediately before the year end, and these goods remain in inventory
D Thatch paid its payables earlier than usual out of a positive cash balance

Answer 103

B Thatch made an unusually large sale immediately before the year end
D Thatch paid its payables earlier than usual out of a positive cash balance An unusually large sale would increase receivables and the current ratio.
If payables are paid out of a positive cash balance then this will reduce both cash (assets) and payables by the same absolute amount. However, since the current ratio is positive (assets are greater than liabilities), the ratio will increase. SAMPLE EXAM

Question 104

Which one of the following best describes the principal difference between fraud and error?
A Fraud may result in the financial statements being material misstated
B Fraud is an intentional act whereas error is unintentional
C A misstatement can be material whether it is caused by fraud or by error
D Fraud may be the result of negligence whereas error is unintentional

Answer 104

B Fraud is an intentional act whereas error is unintentional
It is true that fraud may result in a material misstatement, but this is also true of error so it is incorrect to say that the difference is that fraud may result in material misstatements. It is also true that a misstatement can be material whether it is caused by fraud or by error, but this does not help us to distinguish between them. Fraud is an intentional act and is not merely the result of negligence. Fraud is an intentional act, but error is not.

Question 105

27 Rasvi LLP has been informed by its client, Wilson Ltd, that it has discovered that a payroll fraud was in operation during the previous financial year, a year in respect of which Rasvi LLP gave a ‘clean’ auditor’s opinion.
Wilson Ltd says that Rasvi LLP was responsible for preventing the fraud. A review of the previous year’s audit working papers shows that Rasvi LLP failed to perform any procedures at all in relation to the payroll.
For each of the following statements, select whether the statement is true or false. Rasvi LLP was responsible for preventing the fraud
A True
B False

Rasvi LLP failed to discharge its responsibilities as auditor
C True
D False

Answer 105

Correct answer(s): B False
Correct answer(s): C True
The prevention of fraud is the responsibility of management, not the auditor. However, the auditor is responsible for obtaining evidence to address the risks of material misstatement, which they failed to do in relation to payroll.

Question 106

28 The Welch group is an audit client that operates in the extractive industries and has ownership of a number of mining facilities located in western Australia. These facilities are subject to a number of overseas environmental regulations which govern issues such as the facilities’ use of water, ground vibrations and noise pollution. During the year, the group was found to have breached these regulations at several of its sites.
The statement of profit or loss recognises fines and penalties paid in respect of these breaches. Which of the following best describes the audit risk arising from the regulations?
A Inherent risk
B Control risk
C Detection risk
D Business risk

Answer 106

A Inherent risk
The presence of the regulations gives rise to an inherent risk, against which the entity must put in place controls.
If the question had focused on, for example, management’s process to manage the risk of non- compliance with regulations, then this might have been a control risk. This is not a detection risk because it does not have to do with the auditor’s procedures. Business risk is not a type of audit risk.

Question 107

Difference between transition and physical risks

Answer 107

Transition risks relate to social and economic shifts to a low-carbon economy such as changes to policy, technology and markets. This also includes the risk the company does not adapt to changes to regulation and investor attitudes.

Physical risks arise from the physical effects of climate change. In the agriculture sector droughts may have an impact, for example on irrigation.