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Auditing
Assurance
Services(M)
Semester 1 2019
Semester 1: 2019 Lecture 5:
UNIVERSITY OF ADELAIDE Assessing Inherent Risk and Specific Business Risks,
BUSINESS SCHOOL and Determining Materiality
Dr Phil Saj PhD CPA
University of Adelaide 2

Audit Planning Assess Business Risk

Initial audit planning
Understand the entity and its environment
Identify business risks that may result in material
misstatements in the financial statements
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.

Make a preliminary judgement about materiality SWOT ANALYSIS

Determine Make a preliminary PEST ANALYSIS

inherent risk assessment of control risk
VALUE CHAIN APPROACH
Develop an audit strategy for significant assertions

Perform Preliminary Simple comparison with prior period and

Analytical Procedures industry using ratio analysis

■ At the planning stage, the auditor uses Your knowledge of your client’s industry suggests
analytical procedures as a risk assessment your client is experiencing significant pressure
tool to identify issues of which the he/ she was from competitors undercutting sales prices. You
unaware. perform the following analysis.

■ Enhances understanding of the client and its CLIENT INDUSTRY

environment. 2018 2017 2018 2017
Days in 110 80 81 78
■ Identifies areas that require greatest attention. inventory
■ Highlights unusual relationships and Gross 20.3% 26.4% 27.3% 26.2%
unexpected fluctuations. margin
percent

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 Determine Materiality
■ Materiality for the financial report as a whole.
■ Performance materiality.
■ Materiality specific transaction classes/balances.
■ An item is material if it will affect decisions.
■ The level of materiality set by the auditor in
each audit is therefore determined by his/her
consideration of who uses the financial report
and for what purpose.
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Performance Materiality
“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”. [ASA320.9]
Determine Inherent Risk (IR)
Susceptibility of an assertion to material
misstatement given the inherent and
environmental characteristics assuming
there are no related internal controls [ASA200.13].
Inherent risks arise because of the
nature of the entity, including what it
does, and its environment.
Materiality for the Financial Report
as a Whole
■ The audit must be planned in such a way that the
auditor has a reasonable expectation of detecting
any material misstatements.
■ Where the auditor believes that the risk of
misstatement is higher, materiality will be set lower.
Specific Materiality
■ If there is one or more specific transaction classes/
balances for which misstatements of a lesser
amount are expected to influence users’ decisions,
a lower level of materiality will be applied there.
■ Examples
■ Remuneration
■ Research and Development
■ Items impacting loan covenants
Need to Consider I R at the Financial
Report Level and at the Assertion Level
■ Some Inherent Risks have the potential to impact
widely on the financial statements.
■ Management experience and knowledge
■ Unusual pressure on management
■ Some Inherent Risks have the potential to impact
only particular transaction classes and/ or balances.
■ Accounts requiring high levels of judgment
■ E.g. results of previous audits
■ Audits are undertaken on segments (cycles).
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 Inherent risk associated with
Inherent Risk at the Financial
information technology
Report Level
■ Significant changes in I. T.
■ Integrity of management ■ Insufficient I.T. skills and resources
■ Management experience and knowledge ■ Lack of entity support and focus
■ Unusual pressures on management ■ High dependence on I.T.
■ Reliance on external I.T.
■ Nature of entity’s business
■ Reliance on external I.T.
■ Factors affecting the industry in which
entity operates ■ Reliability and complexity of I.T.
■ Information technology ■ Electronic commerce issues

I R at the Financial Report Level: Example Inherent risk at the assertion level
Inherent Existence of management bonus
risk scheme ■ Accounts likely to require adjustment

Incentive for management to increase ■ Complexity of underlying transactions

Impact recorded profit. E.g. by bringing forward
sales or recording fictitious sales ■ Judgment required in determining account balance
Account ■ Susceptibility of assets to loss or misappropriation
affected
Sales
■ Unusual or complex transactions. Especially
Assertions
affected Cut-off, occurrence; (ASA315.A124) at year end.

Audit
Inspect large entries in sales journal ■ Transactions not subject to ordinary processing
prior to balance date and trace them
procedure to shipping documents

I R at the Assertion Level: Example Assess special areas of business risk

Susceptibility of assets to
Inherent risk Fraud
misappropriation (e.g. silicon chips)

Impact Loss of assets Earnings management

Account bal.
Inventory Illegal acts
affected

Assertion
Existence (ASA315.A124) Related parties
most affected

Audit Inspect inventory records and

procedure
Appropriateness of going concern
compare with physical inventory

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 Fraud
The intentional act by one or more
individuals among management, those
charged with governance, employees
or third parties involving the use of
deception to obtain an unjust or illegal
advantage.
[ASA240 para 11]
Indicators of Fraud [ASA 240. Appendix 3]
Discrepancies in the accounting records
■Transactions that are not recorded in a complete
or timely manner, or are improperly classified.
■ Perform substantive procedures on disaggregated data
Conflicting or missing evidence
■ Missing documents ■ Significant missing inventory
■ Significant unexplained items or reconciliations
Problematic or unusual relationships
Between the auditor and management
■ Unusual delays in response to requests for information.
■ Undue time pressures imposed by management to
resolve complex or contentious issues.
Earnings management
Earnings management is the use of
judgment and / or the structuring of
transactions to alter financial reports to
influence the perceptions of those reading
the reports about the underlying economic
performance of the company and/or to
influence outcomes that are based on
reported accounting numbers.
The auditor’s consideration of fraud
(ASA 240)
■ Intrinsically difficult to detect.
■ Audit should be planned to obtain a reasonable
assurance that fraud has not occurred, or, if it
has, it has been disclosed in the F.R.
■ Need to maintain an attitude of professional
scepticism. (Be aware of the possibility of fraud).
■ There can be greater risk of fraud due to the nature
of an item (e.g. cash), or changing
conditions (e.g. recession).
Audit procedures in response to fraud :
[ASA 240. Appendix 2]
Consideration at the assertion level
■Alter audit approach followed in the previous year
Fraudulent financial reporting
■ Revenue recognition ■ Inventory quantities
■ Management estimates
Misappropriation of assets
■ Analysis of written-off amounts
■ Confirming specific items
Types of Earnings Management
■ 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.
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 Illegal acts: (see ASA 250)
■ Illegal acts are contraventions of laws
and regulations.
■ Auditor must consider impact of any
contravention on the FR.
■ While the audit program does not normally
include procedures to specifically
discover illegal acts, they may be identified
from other procedures.
Preliminary assessment of going
concern (see ASA 570)
■ 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.
■ Consider indicators and mitigating factors
Indicators of G C Problems
ASA 570. A2
Financial
■ Net L or Net C L position
■ Arrears or discontinuance of dividends
Operating
■ Loss of key management without replacement
■ Loss of license and/ or franchise
Other
■ Tech. development that renders product obsolete
■ Failure of other entities in same industry
Related Parties (see ASA 550)
■ See Definition at ASA 550 paragraph 10
■ Important because:
■ Requirements of accounting standards & laws
■ Lack of “market discipline”
■ Source of audit evidence
■ Motivation for such transactions
■ But legal and acceptable
Preliminary assessment of going
concern [ASA570]
■ When planning the audit (and when
undertaking audit procedures and
evaluating the results), the auditor must
consider the appropriateness of the GC
basis of accounting.
■ Also, note Corporations Law requirement
for directors’ declaration, which auditor
reports on.
Mitigating Factors
[See Textbook p.275]
■ Ability to dispose assets
Asset factors ■ Sale and leaseback
■ Unused lines of credit
Debt factors
■ Debt restructuring
■ Postpone expenditures
Cost factors
■ Reduce discretionary expenditures
■ Vary dividend
Equity factors
■ Additional investment
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