Module 13: Audit Process: Fundamental Concepts

Question 1

What is audit risk?

Answer 1

The risk that the auditor gives the wrong opinion on the financial statements when the financial statements are materially misstated.

The auditor will reduce audit risk to an acceptably low level. Giving the incorrect opinion may result in damage to the firm’s reputation and possible regulatory action.

Question 2

What is misstatement?

Answer 2

Where there is a difference between an amount, classification, presentation or disclosure reported in the financial statements and the correct treatment in accordance with the applicable financial reporting framework.
Misstatement can occur from fraud or error.

Question 3

What is the risk-based approach?

Answer 3

Where the auditor tailors the nature, extent and timing of audit procedures performed on each area of the financial statements according to the risk of there being a misstatement in that area.

Question 4

What is the balance required in external audit and how have auditors responded to these pressures?

Answer 4

Shareholders are keen for the auditor to highlight irregularities in the financial statements whilst avoiding undue delay of the publication of the information that is being audited without running up a significant fee.

Responded by:
Providing the highest quality evidence in a given time for a given fee
Ensure that adequate evidence is collected on which the opinion can be based.

Question 5

What are the three fundamental concepts that relate to the practical process of auditing?

Answer 5

1. Materiality
2. Evidence
3. Audit judgement

Question 6

What is materiality?

Answer 6

An expression of the relative significance or importance of a particular matter in the context of the financial statements as a whole. A matter is considered to be material if its omission or misstatement would reasonably influence the economic decisions of users taken on the basis of financial statements.

Question 7

When should materiality be considered by the auditor?

Answer 7

1. Identifying transactions and balances that are individually material (Planning)
2. Evaluating the potential impact of identified risks (planning)
3. Determining the nature, timing and extent of audit procedures (planning/testing)
4. Evaluating whether sufficient appropriate evidence has been gathered (completion)
5. Evaluating the effect of unadjusted misstatements (completion)

Question 8

Methods of gathering evidence?

Answer 8

1. Understanding the entity and the overall control environment - this provides susceptibility of the financial statements to misstatement
2. Testing the controls of the entity - good controls reduce the risk that the figures in the financial statements are incorrect as they will help prevent or detect errors.
3. Testing the numbers in the financial statements - this is called substantive testing and allows the auditor to detect misstatements

Question 9

What is professional scepticism?

Answer 9

It requires an attitude that includes questioning mind that challenges management with a degree of doubt that demands hard evidence, being alert to conditions which may indicate possible misstatement due to error or fraud.

Question 10

What are the three components of audit risk?

Answer 10

1. Inherent risk - The susceptibility of a financial statement account to a material misstatement, irrespective of related internal controls. IR is performed at planning stage.
2. Control risk - The risk that the entity’s controls will not prevent or detect and correct a material misstatement in the financial statements on timely basis . Done at systems and control phase.
3. Detection - The risk that the auditors procedures will not detect material misstatements that exist in the financial statements.

These misstatements may be material, individually or in aggregate.

Question 11

What are the two sources of inherent risk

Answer 11

1. Business risk - Business risks that would have an impact on the financial statements would be considered an inherent risk. Example, business in fast moving tech may have obsolete stock
2. Account specific risk - Accounts that contain non-routine, complex or judgemental transactions or which a significant development has occurred are inherently risky. Example revaluation of property

Question 12

What two categories can the impact of account specific risk and business risk be categorised into?

Answer 12

1. Financial statement level risks - something that will effect the financial statements as a whole
2. Assertion level risks - relate to the specific area of the accounts only.

Question 13

How does control risk increase?

Answer 13

It increases where the internal control systems of an entity are poorly designed.

Question 14

What is risk of material misstatement (ROMM)?

Answer 14

The combination of inherent risk and control risk. It is the risk that a material misstatement may exist in the financial statements prior to the auditor undertaking any procedures.

Question 15

What is detection risk?

Answer 15

Detection risk is the risk that the auditor will not find a misstatement. Once ROMM has been assessed the auditor will know what the level of detection risk needs to be.

Question 16

What is the relationship between ROMM and detection risk?

Answer 16

Inverse

Question 17

Relationship between low ROMM and detection risk?

Answer 17

When ROMM is low there is less chance of an error occurring in the financial statements, therefore the auditor can do less work to detect misstatements. Can accept a much higher level of detection risk (higher risk they will miss something ) as there is less chance of error.

Question 18

Relationship between high ROMM and detection risk?

Answer 18

Where ROMM is high there is a higher chance of an error occurring in the financial statements. Therefore the auditor must do more work to conclude if they are true and fair. So a lower level of detection risk.

Question 19

What is sampling risk?

Answer 19

The risk that testing a sample from a population does not give the same conclusions as testing the whole population. Can be reduced by increasing sample size.

Question 20

Non sampling risk?

Answer 20

The risk that an incorrect judgement is made because the audit procedures used were not appropriate or testing results were wrongly interpreted by audit team.