Topic 6.1 - Assessing Inherent Risk and Specific Business Risks, and Determining Materiality

Question 1

what is Business Risk?

Answer 1

The risk that a company’s business
objectives will not be attained as a result of
internal and external factors…which may
threaten profitability and survival.

Question 2

how are analytical procedures used as a risk assessment tool by the auditor?

Answer 2

■ to identify issues of which the he/ she was unaware
■ Enhances understanding of the client and its environment.
■ Identifies areas that require greatest attention.
■ Highlights unusual relationships and unexpected fluctuations.

Question 3

when is an item material?

Answer 3

An item is material if it will affect decisions.

Question 4

how do auditors use analytical procedures as a risk assessment tool?

Answer 4

■ To identify issues of which the he/ she was
unaware.
■ Enhances understanding of the client and its
environment.
■ Identifies areas that require greatest attention.
■ Highlights unusual relationships and
unexpected fluctuations.

Question 5

what’s the difference between Performance Materiality and Materiality for the Financial Report
as a Whole?

Answer 5

its the amount, or amounts set by the auditor at
less than materiality for the financial report as
a whole to reduce to an appropriately low level
the possibility that the aggregate of
uncorrected and undetected misstatements
exceeds materiality for the financial report as a
whole

Question 6

how is the level of materiality affected if the risk of

misstatement is higher?

Answer 6

the level of materiality is set lower
inverse relationship
to ensure no misstatements slip through the cracks

Question 7

what are three examples of Specific Materiality, where lower level of materiality will be applied due to amounts having greater impact on users decisions?

Answer 7

■ Remuneration
■ Research and Development
■ Items impacting loan covenants

Question 8

why does inherent risk arise?

Answer 8

Inherent risks arise because of the
nature of the entity, including what it
does, and its environment.

Question 9

what are two examples of inherent risk (IR) impacting a company through its management?

Answer 9

■ Management experience and knowledge

■ Unusual pressure on management

Question 10

what are two levels of IR?

Answer 10

Financial Report Level (impacts the whole of the financial report) and Assertion Level (impact
only particular transaction classes and/ or balances)

Question 11

What are 6 examples of IR at Financial Report Level?

Answer 11

■ Integrity of management
■ Management experience and knowledge
■ Unusual pressures on management
■ Nature of entity’s business
■ Factors affecting the industry in which entity operates
■ Information technology

Question 12

if there is Incentive for management to increase
recorded profit. E.g. by bringing forward
sales or recording fictitious sales,
what level of IR is this?
what assertions are affected?
what would the audit procedure be?

Answer 12

• financial report level
• occurrence, cut-off
• Inspect large entries in sales journal prior to balance date and trace them to shipping documents

Question 13

What are 6 examples of IR at Assertion Level?

Answer 13

■ Accounts likely to require adjustment
■ Complexity of underlying transactions
■ Judgment required in determining account balance
■ Susceptibility of assets to loss or misappropriation
■ Unusual or complex transactions. Especially
at year end.
■ Transactions not subject to ordinary processing

Question 14

If Susceptibility of assets to misappropriation is high (e.g. silicon chips):
what level of IR is this?
what assertions are affected?
what would the audit procedure be?

Answer 14

• Assertions level
• existence
• Inspect inventory records and compare with physical inventory

Question 15

What is Fraud?

Answer 15

The intentional act by one or more
individuals involving the use of
deception to obtain an unjust or illegal
advantage.

Question 16

fraud is difficult to detect, what should an auditor maintain throughout the audit? if fraud is detected what should an auditor do?

Answer 16

maintain an attitude of professional
scepticism.
if detected they must report to appropriate level of management.

Question 17

what are three indicators of fraud?

Answer 17

• Discrepancies in the accounting records
• Conflicting or missing evidence
• Problematic or unusual relationships between the auditor and management

Question 18

What is earnings management?

Answer 18

manipulating the financial reports to
influence the perceptions of those reading
the reports about the underlying economic
performance of the company, to influence outcomes that are based on reported accounting numbers

Question 19

list 4 Types of Earnings Management?

Answer 19

■ Intentional violation of accounting standards
and other reporting requirements that are
themselves immaterial.
■ Inappropriate revenue recognition.
■“Big bath” changes under the guise of
restructuring.
■ Improper accruals and estimations of liabilities
in good times.

Question 20

what is going concern?

Answer 20

Going concern: for the relevant period
(12 months), the company is able to pay
debts when due, and continue in
operation without any intention or
necessity to liquidate or otherwise
wind up operations.

Question 21

When must the auditor making an assessment of going concern?

Answer 21

When planning the audit the auditor must
consider the appropriateness of the GC
basis of accounting.

NOTE -Corporations Law requirement
for directors’ declaration, which auditor
reports on.

Question 22

list two operating and two financial GC problem indicators?

Answer 22

Op
■ Loss of key management without replacement
■ Loss of license and/ or franchise
Fin
■ Net L or Net C L position
■ Arrears or discontinuance of dividends

Question 23

what are four factors that can mitigate a GC problem?

Answer 23

• asset factors (dispose/ sale lease back)
• debt factors (unused credit/debt restructuring)
• cost factors (reduce or postpone)
• equity factors (additional investment/ vary dividend)

Question 24

Briefly state the auditor’s responsibility in relation to fraud when planning an audit

Answer 24

The audit must be planned to obtain a reasonable assurance that fraud that may be material has not occurred, if it has occurred, the effect of the fraud has been adequately reported

Question 25

When evaluating the appropriateness of the going concern assumption at the planning stage of an audit, the auditor may consider mitigating factors. State one asset factor that may mitigate a going concern problem.

Answer 25

Assets
 Disposal of surplus assets
 Delay replacement of an asset
 Lease rather than purchase an asset
 Factoring of receivables
 Enter into a sale and leaseback arrangement

Question 26

When evaluating the appropriateness of the going concern assumption at the planning stage of an audit, the auditor may consider mitigating factors. State one debt factor that may mitigate a going concern problem

Answer 26

 Defer dividend payments
 Seek additional contributions from owners
 Increase cash distribution from subsidiaries