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.

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. Misstatements can arise from fraud or error.

Question 3

What is the risk-based approach?

Answer 3

This is where auditors 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.

(it allows auditors to focus audit work on the areas that are most likely to contain issues and so ensures that the audit is efficient)

Question 4

What is materiality?

Answer 4

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 condiered to be material if its omission or misstatement would reasonably influence the economic decisions of the users taken on the basis of the financial statements.

An item can be material because of its size or nature.

Question 5

How does materiality impact audit work?

Answer 5

It determines the scope of the work performed (which items are tested and to what degree)

It determines the nature of the final audit opinion. Where a material misstatement exists in the financial statements, they do not show a true and fair view.

Question 6

Why is gathering evidence during audits important?

Answer 6

An auditor can only express an opinion over whether the accounts give a true and fair view if they have collected sufficient and appropriate evidence to support the figures.

Question 7

What are the three methods of gathering evidence?

Answer 7

Understanding the entity and the overall control environment - this provides the risks that exist due to the nature of the entity (predominantly done at the planning stage of the audit)

Testing the controls of the entity - Good controls reduce the risk that figures in financial statements are incorrect and they will help prevent or detect errors/fraud. (done at the systems and controls stage)

Testing the numbers in the financial statements - this is substantive testing and allows auditors to detect misstatements in the financial statements. (Done at the substantive testing and completion stages of the audit)

Question 8

What is audit judgement often referred to as?

Answer 8

The appropriateness of an auditor’s judgement is dependent on the competence and experience of the auditor and the need to comply with accepted methodology, this is often known as professional judgement.

Question 9

What is professional scepticism?

Answer 9

Having an attitude that includes a 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, and a critical assessment of audit evidence.

Question 10

What are the three risk components of audit risk?

Answer 10

Inherent Risk (IR) - The susceptibility of a financial statement account to a material misstatement, irrespective of related internal controls.

Control Risk (CR) - The risk that the entity’s controls will not prevent or detect and correct a material misstatement in the financial statements on a timely basis.

Detection Risk (DR) - The risk that the auditor’s procedures will not detect material misstatements that exists in the financial statements.

Question 11

What is the audit risk formula?

Answer 11

Audit risk = Inherent Risk X Control Risk X Detection Risk

Question 12

Where can inherent risk come from?

Answer 12

Business risk - business risks that would have an impact on the financial statements would be considered an inherent risk

Account specific risk - accounts that contain non-routine, complex or judgemental transactions are inherently risky

Question 13

What are the two categories that risk can be categorised into?

Answer 13

Financial statement level risks - Something that will affect the financial statement as a whole (the impact of a misstatement would be at the financial statement level)

Assertion level risks - this relates to a specific area of the accounts only (the impact of misstatement would be at the assertion level)

Question 14

Where does control risk come from?

Answer 14

Control risk increases where the internal control systems at an entity are poorly designed or do not operate effectively

Question 15

What is risk of material misstatement (ROMM)?

Answer 15

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 16

How is risk of material misstatement (ROMM) assessed?

Answer 16

It is assessed as either low, medium or high.

Question 17

What is the role of detection risk in the audit risk equation?

Answer 17

Detection risk is the balancing figure in the audit risk equation. Detection risk is the risk that the auditor will not find a misstatement.

Detection risk and ROMM have an inverse relationship

Question 18

What does low detection risk mean?

Answer 18

High Risk in ROMM and therefore more work needs to be done to reduce the audit risk to low (auditors can only accept a lower level of detection risk as there are potentially a lot of material misstatement in the accounts)

Question 19

What does high detection risk mean?

Answer 19

Low risk in ROMM and therefore less work can be done to reduce the audit risk to low (auditors can accept a higher level of detection risk as there is less chance errors exist in the first place)

Question 20

What are the two elements of detection risk?

Answer 20

Sampling Risk (SR) - The risk that testing a sample from a population does not give the same conclusions as testing the whole population would have given. It can be reduced by increasing the sample size.

Non-sampling risk (NSR) - The risk that an incorrect judgement is made because the audit procedures used were not appropriate or testing results were wrongly interpreted by the audit team. It can be reduced through adequate planning, professional scepticisim and adequate review of work performed.