Chapter 4 - Risk Flashcards
Objectives of an auditor
ISA 200 Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with ISAs.
To obtain reasonable assurance, the auditor shall obtain sufficient appropriate evidence to reduce audit risk to an acceptably low level.
Audit risk
The risk that the auditor expresses an inappropriate audit opinion.
ISA 315 Identifying and Assessing the Risks of Material Misstatement Through Understanding the Entity and its Environment.
The objective of the auditor is to identify and assess the risk of material misstatement providing a basis for designing and implementing responses to the assessed risks of material misstatement.
Misstatement
A difference between the amount, classification, presentation or disclosure of a reported financial statement and the amount, classification, presentation or disclosure required in accordance with the applicable financial reporting framework.
Auditors will be able to:
- Identify areas of the FS where misstatements are likely to occur early in the audit.
- Plan procedures that address the significant risk areas identified.
- Carry out an efficient, focuses and effective risk.
- Minimise the risk of issuing an inappropriate audit opinion to an acceptable level.
- Reduce the risk of reputation and punitive damages.
Materiality
ISA 320 Materiality in Planning and Performing an Audit
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 FS.
Is a matter of professional judgement and the auditor must consider.
- whether the misstatement affects the economic decision of the users.
- the size and nature of misstatements.
- the information needs of the users as a group.
Performance materiality
ISA 320
The amount set by the auditor at less than materiality for the FS 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.
- The auditor sets performance materiality at a lower level than overall materiality.
- The auditor can then identify misstatements.
- This reduces the risk that the auditor will fail to identify misstatements that are material when added together.
Audit risk
The risk that the auditor express an inappropriate audit opinion.
Audit risk is made up of 2 components: risk of material misstatement and detection risk.
Risk of material misstatement
The risk the FS are materially misstated prior to audit and consists of two components, inherent risk and control risk.
Inherent risk - 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.
Control risk - the risk a misstatement that could occur that could be material will not be prevented or detected and corrected on a timely basis by the entity’s internal controls.
Detection risk - the risk 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.
Detection risk comprises:
Sampling risk - the risk the auditors conclusion based on a sample is different from the conclusion that would be reached if the whole population were tested.
Non sampling risk - the risk the auditors conclusion is inappropriate for any other reason e.g the application of inappropriate procedures or the failure to economise a misstatement.
Professional scepticism
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 Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with ISA)
How to apply professional scepticism
Requires the auditor to be alert to:
- Audit evidence that contradicts other audit evidence.
- Information that questions 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.
Risk assessment procedures
- Enquiries with management of appropriate individuals within the internal audit department and others within the client entity.
- Analytical procedures
- Observation and inspection
Analytical procedures
ISA 520 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.
Required to perform analytical procedures as risk assessment procedures in order to
- Obtain an understanding of the entity and its environment
- Assist in assessing the risks of material misstatement
- Identify unusual transactions or events and amounts, ratios and trends.
- Assist the auditor in identifying risks of material misstatement due to fraud.
Analytical procedures include comparisons of the entity’s financial information e.g.
- Comparable periods for prior periods
- Anticipated results such as budgets or forecasts, or estimation of depreciation.
- Similar industry information.
Analytical procedures also include consideration of relationships
- Among elements of financial information expected to conform 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.
Profitability Ratios
Gross margin = Gross profit / Sales revenue X 100%
Net margin = Profit before tax / Sales revenue X 100%
Efficiency ratios
Receivables days = Receivables / Revenue X 365
Payables days = Payables / Purchases X 365
Inventory days = Inventory / Cost of Sales X 365
Liquidity ratios
Current ratio = Current assets / Current liabilities
Quick ratio = (Current assets - Inventory)/ Current liabilities
Investor ratios
Gearing = Borrowings / Share capital + Reserves
ROCE = Profit before interest and tax / (Share capital + Reserves + Borrowings)
