Week 4 Flashcards
Audit risk
Audit risk is the risk that an auditor expresses an inappropriate audit opinion when a financial report is materially misstated (ASA 200; ISA 200).
This means the auditor gives an opinion that the financial report is true and fair when it contains a significant error or fraud.
Audit risk can never be zero.
Audit risk is reduced during risk response phase by identifying the key risks and adjusting audit effort accordingly.
Stages in audit risk minimisation:
Assess inherent risk:
Identification of accounts and related assertions most at risk of material misstatement .
Assertions are statements made by management about recognition, measurement, presentation and disclosure of items in financial report and notes.
All inventory items stated on balance sheet actually exist.
Risks are more significant when they involve:
fraud
related to significant economic or accounting developments
complex transactions
significant related party transactions
significant subjectivity in measurement of financial information
significant transactions outside the client’s normal course of business.
Assess control risk:
Assessment of client’s system of internal controls.
Auditor plans to undertake detailed testing of each identified account:
Based on auditor’s assessments of riskiness of account and related assertions, and effectiveness of the client’s system of internal controls.
Audit risk is a function of:
Inherent risk:
Risk that a material misstatement could occur.
Control risk:
Risk that client’s system of internal controls will not prevent or detect such a material misstatement.
Detection risk:
Risk that the auditor’s testing procedures will not be effective in detecting a material misstatement, should there be one system of internal controls.
The audit risk model and its components:
AR = f(IR, CR, DR)
AR = Audit risk IR = Inherent risk CR = Control risk DR = Detection risk
Audit risk plan and perform
Auditor will plan and perform their audit to reduce audit risk to an acceptably low level (ASA 200; ISA 200).
There is an inverse relationship between IR and CR and DR.
Materiality
Materiality guides audit planning, testing, and assessment of information in financial report.
Information is material if it impacts on the decision-making process of users of the financial report.
Qualitative and quantitative materiality:
Information could be considered material because of its qualitative or quantitative characteristics.
QUALITATIVE MATERIALITY
NATURE OF THE ITEM
Fraud
Non-compliance with laws
Related party transactions
Change of accounting methods
QUANTITATIVE MATERIALITY
MAGNITUDE OF ITEM
Set as a % of relevant base
Setting materiality:
Auditor uses professional judgement.
Audit firms vary in methods to set materiality percentages in the risk assessment phase to derive at an appropriate base percentage.
Balance sheet bases include total assets or equity.
Income statement bases include profit before tax, revenue or gross profit.
Setting lower materiality level during planning increases quality and quantity of evidence required to be gathered.
Audit strategy
Auditor must establish an overall audit strategy (ASA 300; ISA 300):
sets scope, timing, and direction of the audit
provides basis for developing detailed audit plan
is based on preliminary assessments of IR and CR.
Client approaches to measuring performance
As part of gaining understanding of client, auditor should learn how client measures its own performance.
Client uses key performance indicators (KPIs) to monitor and assess its performance and staff performance, and KPIs can be written into contracts between client and others.
Auditor needs to understand what client focuses on, and what is potentially at risk of misstatement.
Client approaches to measuring performance
Profitability:
Profit by division, branch, manager etc. Price earnings ratio (P/E). Earnings per share (EPS): Decline could signal pressure on management. Cash Earning per share (CEPS). Inventory turnover: Decline could signal overvalued stock.
Client approaches to measuring performance
Liquidity:
Ability of company to meet its cash needs in short and long term.
Ratios can be written into debt contracts (as covenants) and restrict client’s actions.
Client potentially under pressure to misstate accounts included in ratios.
Analytical procedures
Evaluation of financial information by studying plausible links among both financial and non-financial data (ASA 520; ISA 520).
Identify fluctuations in accounts that are inconsistent with auditor’s expectations based on their understanding of the client.
Analytical procedures can be conducted throughout audit:
Risk assessment phase – risk identification.
Risk response phase – estimating account balances.
Reporting – overall review.
Analytical procedures are conducted at the risk assessment phase of the audit to:
highlight unusual fluctuations in accounts
aid in risk identification
enhance the understanding of the client
identify accounts at risk of material misstatement
risk assessment phase analytical procedures.
Analytical procedures
Comparisons:
Account balances for the current year and the previous year.
Account balance for the current year and the budget.
Auditor will assess these changes in light of their expectations based upon their understanding of the client.
Analytical procedures
Trend analysis:
Comparison of account balances over time.
Select base year, restate all accounts in subsequent years as a % of that base.
Auditor should factor in client and economic changes, and form expectations of reasonable changes in balances over time.
Analytical procedures
Common-size analysis (vertical analysis):
Comparison of account balances to single line item.
Balance sheet – express each item as % of total assets.
Income statement – express each item as % of sales.
Using analysis over several years, auditor can see how each account contributes to totals, and how this changes over time.
Analytical procedures
Ratio analysis:
Assess relationship between various financial report balances, and between them and non-financial items. An auditor will calculate: profitability ratios liquidity ratios solvency ratios.
Profitability ratios:
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Liquidity ratios
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Solvency ratios
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Interpreting results of ratio analysis:
Compare results to previous years’, budgets, competitors.
Discuss significant variation with management.
Consider effects on future viability of company (going concern risk).
Lack of variation in results could be unexpected if conditions have changed.
Where results are unusual or unexpected, investigate further because it indicates risk of material misstatement.
Other analytical procedures:
Multidimensional analysis involves sorting client data into various dimensions or measures.
Journal entry summaries provide condensed overviews of transactions.
Validation reports can be used to report on the validity of the client’s data.
Criteria-generated reports are summaries of information and data based on conditions set by the auditor.
Times series analysis can be used to analyse data that occur regularly within the client.
Regression analysis can be used to investigate the relationships between different groups of data or variables.
Factors to consider when conducting analytical procedures:
Has client data been audited? Is external data reliable?
Poor controls would signal higher risk in relying on analytical procedures.
Change in accounting methods could distort data.
Auditor may have access to half-year results only.
Reliability of budget setting process – is client continually missing budgeted targets?
Are industry comparisons valid?
