Week 4

Question 1

Audit risk

Answer 1

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.

Question 2

Stages in audit risk minimisation:

Assess inherent risk:

Answer 2

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.

Question 3

Risks are more significant when they involve:

Answer 3

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.

Question 4

Assess control risk:

Answer 4

Assessment of client’s system of internal controls.

Question 5

Auditor plans to undertake detailed testing of each identified account:

Answer 5

Based on auditor’s assessments of riskiness of account and related assertions, and effectiveness of the client’s system of internal controls.

Question 6

Audit risk is a function of:

Answer 6

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.

Question 7

The audit risk model and its components:

Answer 7

AR = f(IR, CR, DR)

AR = Audit risk
IR = Inherent risk
CR = Control risk
DR = Detection risk

Question 8

Audit risk plan and perform

Answer 8

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.

Question 9

Materiality

Answer 9

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.

Question 10

Qualitative and quantitative materiality:

Answer 10

Information could be considered material because of its qualitative or quantitative characteristics.

Question 11

QUALITATIVE MATERIALITY

NATURE OF THE ITEM

Answer 11

Fraud
Non-compliance with laws
Related party transactions
Change of accounting methods

Question 12

QUANTITATIVE MATERIALITY

MAGNITUDE OF ITEM

Answer 12

Set as a % of relevant base

Question 13

Setting materiality:

Answer 13

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.

Question 14

Audit strategy

Answer 14

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.

Question 15

Client approaches to measuring performance

Answer 15

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.

Question 16

Client approaches to measuring performance

Profitability:

Answer 16

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.

Question 17

Client approaches to measuring performance

Liquidity:

Answer 17

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.

Question 18

Analytical procedures

Answer 18

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.

Question 19

Analytical procedures can be conducted throughout audit:

Answer 19

Risk assessment phase – risk identification.
Risk response phase – estimating account balances.
Reporting – overall review.

Question 20

Analytical procedures are conducted at the risk assessment phase of the audit to:

Answer 20

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.

Question 21

Analytical procedures

Comparisons:

Answer 21

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.

Question 22

Analytical procedures

Trend analysis:

Answer 22

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.

Question 23

Analytical procedures

Common-size analysis (vertical analysis):

Answer 23

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.

Question 24

Analytical procedures

Ratio analysis:

Answer 24

Assess relationship between various financial report balances, and between them and non-financial items.
An auditor will calculate:
profitability ratios
liquidity ratios
solvency ratios.

Question 25

Profitability ratios:

Answer 25

slide 31

Question 26

Liquidity ratios

Answer 26

slide 32

Question 27

Solvency ratios

Answer 27

slide 33

Question 28

Interpreting results of ratio analysis:

Answer 28

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.

Question 29

Other analytical procedures:

Answer 29

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.

Question 30

Factors to consider when conducting analytical procedures:

Answer 30

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?