SYLLABUS AREA B- RISK

Question 1

what are the four types of audit opinions an auditor may give?

Answer 1

1- unmodified opinion- FS GIVE A TRUE AND FAIR VIEW.

auditor concludes that FS are presented fairly, in all material aspects in accordance with the applicable financial reporting framework

Modified opinions:
1-qualified opinion: EXCEPT FOR ____, FS give a true and fair view.
it is the opinion that is expressed when:
a) auditor has obtained sufficient appropriate evidence, concluding that the misstatements, individually or aggregate, are material but not pervasive (extensive) to the financial statements
b) auditor is unable to obtain sufficient appropriate evidence on which to base the opinion, but concludes that the possible effects on the financial statements of undetected misstatements, if any could be material but not pervasive.

2- adverse opinion: F/S DO NOT GIVE A TRUE AND FAIR VIEW, expressed when auditor obtains sufficeint appropriate evidence, concluding that misstatements, individually or in the aggregate, are both material and pervasive to the financial statements.

3- disclaimer: WE DO NOT EXPRESS AN OPINION.
when auditor is unable to obtain sufficient appropriate evidence to form an opinion. so auditor concludes that the possible effects on the FS of any undetected misstatements, could be both material and pervasive.

Question 2

what would happen if auditor gave an unmodified opinion when the FS are materially misstated?

Answer 2

• auditor could be sued by the intended users.
  -disciplinary action would be taken by relevant professional body.
• firm could damage it’s reputation.

Eg. Arthur Anderson didn’t give correct opinion about enron.

Question 3

Define audit risk. what are the three type of risks that make up audit risk?

Answer 3

Audit risk is the risk that auditor will give an incorrect opinion by missing material errors and fraud in financial statements.

audit risk comprises of risk of material misstatement and detection risk/
1- inherent risk (MM)
2- control risk (MM)
3- detection risk

Question 4

what is the risk of material misstatement?

Answer 4

Risk of material misstatement is the risk that the financial statements are materially misstated prior to the audit, due to fraud or errors

Question 5

what is a misstatement?

Answer 5

‘A difference between the amount, classification, presentation, or disclosure of a reported financial statement item and the amount, classification, presentation, or disclosure that is required for the item to be in accordance with the applicable financial reporting framework. Misstatements can arise from error or fraud.’

Question 6

3 categories of misstatements?

Answer 6

There are three categories of misstatements:
(i) Factual misstatements: a misstatement about which there is no doubt.

(ii) Judgmental misstatements: a difference in an accounting estimate that the auditor considers unreasonable, or accounting policies that the auditor considers inappropriate.

(iii) Projected misstatements: auditor’s best estimate of the total misstatement in a population through the projection of misstatements identified in a sample.

Question 7

what is inherent risk?

Answer 7

Inherent risk is 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

easy words;
risk of material misstatement due to
-complex A/C treatments
-final time adoption of IFRS
-inclusion of estimates

Question 8

what are the qualitative and quantitative inherent risk factors?

Answer 8

• complexity
• subjectivity
• change
• uncertainty
• susceptibility to misstatement due to management bias.

Question 9

what is control risk?

Answer 9

Control risk is the risk that a material misstatement will not be prevented, or detected on a timely basis by the company’s internal controls.
Control risk may be high either because they aren’t designed sufficiently or they aren’t being implemented

Question 10

what is detection risk?

Answer 10

Detection risk is the risk that the audit procedures being done to reduce audit risk to an acceptably low level will not detect a material misstatement ,

Question 11

what are the two elements of detection risk?

Answer 11

1) Sampling risk is when the sample taken by auditor is not representative of the population it was chosen from, and the auditor’s conclusion based on the sample is different from the conclusion that would be reached if the whole population was tested.

2) Non-sampling risk is the risk that the auditor’s conclusion is inappropriate for any other reason, e.g. the application of inappropriate procedures or the failure to recognise a misstatement.

Question 12

what can auditor do to reduce detection risk?

Answer 12

• professional scepticism:
- use experienced staff in risky areas
-more supervision.
-hire experts when needed
– less reliance on internal controls
– more substantive procedures.

Question 12

Why is there a need to conduct a thorough assessment of risk?(5)

Answer 12

In conducting a thorough assessment of risk, auditors will be able to:
• Identify areas of the financial statements where misstatements are likely to occur early in the audit.
• Plan procedures that address the significant risk areas identified.
• Carry out an efficient, focused and effective audit.
• Reduce the risk of issuing an inappropriate audit opinion to an acceptable level.
• Minimise the risk of reputational and punitive damage.

Question 13

What is the objective of the auditor regarding Material misstatements according to IAS?

Answer 13

-The objective of the auditor is to identify and assess the risk (is it fraud or error?)
-understanding the entity and its environment, and it’s internal controls
-designing procedures for the assessed risks

Question 14

What is professional skepticism ? How can an auditor apply professional skepticism?

Answer 14

Professional scepticism means a questioning attitude, being alert to possible misstatements
, and a critical assessment of audit evidence.

Professional scepticism requires the auditor to be alert to:
• Audit evidence that contradicts other audit evidence.
• 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.

Client generated evidence is least reliable so always look for third party evidence

Question 15

Define the term materiality

Answer 15

Info is material if it’s omission could distort the decision of FS users
It is the judgement of the auditor
Varies from company to company

Question 16

How is materiality determined?

Answer 16

The determination of materiality is a matter of professional judgment. The auditor must consider:

• Whether the misstatement would affect the economic decision of the users
• Both the size and nature of misstatements
• The information needs of the users as a group.

Materiality is a subjective matter and as such should be considered in light of the client’s circumstances.

Question 17

What is the financial threshold for materiality according to IAS 320?

Answer 17

A matter is material if it is:

• 1⁄2–1% of revenue
• 5% – 10% of profit before tax
• 1 – 2% of total assets.

The above are common benchmarks but different audit firms may use different benchmarks or different thresholds for each client.

Question 18

What does it mean to be material by nature?

Answer 18

Materiality is not just financial, some items may be material by nature.

-non compliance with regulations
-non compliance with debt covenants.
-Misstatements that, when adjusted, would turn a reported profit into a loss for the year.
-Misstatements that, when adjusted, would turn a reported net-asset position into a net-liability position.
-Transactions with directors, e.g. salary and benefits, personal use of assets, etc.
-Disclosures of future legal claims ,going concern issues, etc could influence users’ decisions.

Question 19

How is a suitable preliminary materiality limit set?

Answer 19

A suitable preliminary materiality level is most likely to be one that lies within the overlap of the ranges calculated for profit and total assets.
Materiality is not normally based on revenue except in circumstances when it would not be meaningful to base materiality on profit,
e.g. because the entity being audited is a not-for-profit entity or where there is a small profit (or a loss) as this will result in over-auditing of the financial statements

Preliminary materiality should be set at a lower level if it’s the first audit

Question 20

What is performance materiality and what is the need for it?

Answer 20

It is unlikely, in practice, that auditors will be able to design tests that identify individual material misstatements. It is much more common that misstatements are material in aggregate

performance materiality is the amount of money that the auditors use as a threshold to determine if financial errors are significant enough to affect the financial statements as a whole.

• The auditor sets performance materiality at a value lower than overall materiality, and uses this lower threshold when designing and performing audit procedures.
• This reduces the risk that the auditor will fail to identify misstatements that are material when added together.

Question 21

What are the risk assessment procedures to be followed by the auditor? AEIOU

Answer 21

The auditor should perform the following risk assessment procedures:
• Enquiries with management, of appropriate individuals within the internal audit function (if there is one), and others (with relevant information) within the client entity (e.g. about external and internal changes the company has experienced)
• Analytical procedures
• Observation (e.g. of control procedures)
• Inspection (e.g. of key strategic documents and procedural manuals).

Question 22

How may an auditor understand an entity and its environment?

Answer 22

In order to identify the risks of material misstatement in the financial statements the auditor is required to obtain an understanding of: their clients; their clients’ environments; and their clients’ internal controls. This generally includes:

Relevant industry, regulatory and other external factors, including:
– Financial reporting framework
– Legislation and regulations
– Competition
– Economic conditions.
-Nature of the entity, including: Nature of products and services,Ownership and governance structures,Investment and financing activities, Key customers and suppliers.

-Entity’s selection and application of accounting policies.
-Entity’s objectives, strategies and related business risks

Industry developments
New products and services
New accounting requirements
Current and future financing requirements.

• Measurement and review of the entity’s financial performance
– Performance measures and related incentives to commit fraud
through management bias
– Budgets, forecasts and variance analyses and performance reports
– Comparison of performance with competitors
– Consideration of performance related bonuses.
• Internal controls relevant to the audit (covered in more detail in the Systems and controls chapter).
If the entity has an internal audit function, obtaining an understanding of that function also contributes to the auditor’s understanding, in particular the role that the function plays in the entity’s monitoring of internal control over financial reporting.

Question 23

Where can an auditor find the information needed to understand the entity and its environment?

Answer 23

From the audit firm:
Last years audit team
last year’s working papers
Manager
Partner
Industry experts

From you: past experience

From the client
Discussions, website, brochures, observation

From external sources
The Internet
Trade press
Companies house
Credit reference agencies
Industry surveys

Question 24

What are analytical procedures? And why are they needed?

Answer 24

Analytical procedures are methods used by auditors to examine companies financial information and compare it to industry standards and past performance. Helps identify errors or inconsistencies in FS that need further investigation

Analytical procedures are fundamental to the auditing process.
The auditor is required to perform analytical procedures as risk assessment procedures in accordance with ISA 315 in order to:
• Identify aspects of the entity of which the auditor was unaware.
• Assist in assessing the risks of material misstatement in order to provide a basis for designing and implementing responses to the assessed risks.
• Help identify the existence of unusual transactions or events, and amounts, ratios, and trends that might indicate matters that have audit implications.
• Assist the auditor in identifying risks of material misstatement due to fraud.

Question 25

What are the different types of analytical procedures?

Answer 25

Analytical procedures include comparisons of the entity’s financial information
with, for example:
• prior periods info
• Anticipated results such as budgets or forecasts, or
expectations of the auditor, such as an estimation of depreciation.
• Similar industry information, such as a comparison of the entity’s ratio of sales to accounts receivable with industry averages or with other entities of comparable size in the same industry.

Analytical procedures also include consideration of relationships, for example:
• Among elements of financial information that would be expected to conform to 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.

Computer assisted auditing techniques are now often used to perform data analysis.

Question 26

Add which stage are analytical procedures performed in the audit?

Answer 26

Analytical procedures can be used at all stages of an audit.
-ISA requires the auditor to perform analytical procedures as risk assessment procedures in order to help the auditor to obtain an understanding of the entity and assess the risk of material misstatement.

ISA also allows the auditor to use analytical procedures as a substantive procedure during the final audit to help detect misstatement.

In addition, ISA requires the auditor to use analytical procedures at the completion stage of the audit when forming an overall conclusion as to whether the financial statements are consistent with the auditor’s understanding of the entity.

Question 27

What are profitability rations and how might they be relevant to an auditor performing analytical procedures?

Answer 27

Gross margin: gross profit/sales revenue × 100% Net margin: profit before tax/sales revenue × 100%
Auditors would expect the relationships between costs and revenues to stay relatively stable. Things that can affect these ratios include: changes in sales prices, bulk purchase discounts, economies of scale, new marketing initiatives, changing energy costs, wage inflation.
Therefore, any unusual fluctuation in the profitability ratio could mean that the figures are materially misstated. For example, if gross profit margin improves, this could be caused by any or all of the following:
• Overstated revenue because of inappropriate revenue recognition or cut-off issues.
• Understated cost of sales because of incomplete recording of purchases.
• Understated cost of sales because of overvaluation of closing inventory.

Question 28

What are efficiency ratios and how might they be relevant to an auditor performing analytical procedures?

Answer 28

Efficiency ratios
Receivables days: receivables/revenue × 365 Payables days: payables/purchases × 365 Inventory days: inventory/cost of sales × 365
These ratios show how long, on average, companies take to collect cash from customers and pay suppliers and how many days inventory is held before being sold. Companies should strive to reduce receivables and inventory days to an acceptable level and increase payables days because this strategy maximises cash flow.
Any changes can indicate significant issues, such as:
• Worsening credit control and increased need for receivables allowance
• Slow-moving and possible obsolete inventory that could be overvalued
• Poor cash flow leading to going concern problems which would require disclosure.

Question 29

Liquidity ratios and their relevance in audit

Answer 29

Liquidity ratios
Current ratio: current assets/current liabilities
Quick ratio: (current assets-inventory)/current liabilities
These ratios indicate the ability of a company to meet its short term debts. As a result these are key indicators when assessing going concern.

Question 30

Investor ratios and their relevance in audit?

Answer 30

Investor ratios
Gearing: borrowings/(share capital + reserves)
Return on capital employed (ROCE): profit before interest and tax/(share capital + reserves + borrowings)
Gearing is a measure of external debt finance to internal equity finance. ROCE indicates the returns those investments generate.
Any change in gearing or ROCE could indicate a change in the financing structure of the business or it could indicate changes in overall performance of the business. These ratios are important for identifying potentially material changes to the statement of financial position (new/repaid loans or share issues) and for obtaining an overall picture of the annual performance of the business.

Question 31

How are audit risk exam questions supposed to be answered?

Answer 31

-it is important to answer the question from an auditor’s perspective rather than the perspective of the client.
-A common mistake that students make in exams is to explain business risks rather than audit risks. Business risks are not examinable in this syllabus.

Eg. Customers are struggling to pay debts.
Audit risk: Receivables may be overstated if bad debts are not written off.
Business risk: Bad debts may arise reducing the profits of the company.

In the exam make sure your risks link with a risk of material misstatement or a detection risk.

A risk of material misstatement will affect either a balance in the financial statements, a disclosure in the notes to the financial statements or the basis of preparation.

Once the risks are identified, you must suggest a relevant audit response to the risk identified.

The response must specifically deal with the risk. You should not suggest audit responses that address the balance generally.

Eg.
Audit risk: Overstatement of receivables due to bad debts not written off.

Relevant response:

Inspect after date cash receipts from customers to see if paid post year-end proving the debt is appropriately valued.
Review the aged receivables listing for old debts which may not be recoverable and discuss the need for an allowance to be made with management.

Irrelevant response:

Obtain the receivables listing and cast it to verify arithmetical accuracy.
The risk identified is overvaluation. Obtaining the listing does not provide evidence that the debts are appropriately valued.
Obtain external confirmation from customers to confirm existence.
External confirmation is providing evidence of existence but not valuation.
The company should improve their credit control procedures.
This is a client response not an auditor response.