Audit risk is a combination of the risk that the financial statements being audited may

contain material errors and that these errors may not be detected by the auditor’s testing
procedures. Risk can be categorized as ‘low, medium or high’ and is evaluated during the
planning stage of an audit. The auditor should devote attention to the critical areas of the
financial statements by considering and evaluating materiality and risks specific to the
company. Materiality limits should be set at the planning stage of the audit to act as a
guideline for deciding whether adjustment should be made to the financial statements.

Briefly describe what you understand by the terms ‘inherent risk’, ‘control-risk’
‘detection risk’ and ‘audit risk.
Inherent Risk: Inherent risk is arise due to error or omission of factor other than internal
control. It may arise due to nature of the entity or the financial statements.
Control risk: The risk that could be material, could be material, would not be prevented,
detected or corrected on time by entity’s internal controls. Such risks are high when the
internal control is not applied effectively.
Detection risk: It may be material risk arise by procedures performed by auditor. This can
be sampling risk or non- sampling risk.
Audit risk: The risk that auditor expresses when there is material misstatement of the
financial statements. It means that the auditor’s opinion is different from reality due to
misstated financial statements.

List eight factors which the auditor would bear in mind when assessing
the audit risk of a company. You should set out your answer under the
headings ‘inherent risk’ and ‘control risk’.
 Nature of the industry
 Use of accounting standard and its treatment
 Account balances
 Valuation of assets
 Control Environment
 Information System
 Monitoring
 Risk assessment process

Define and explain the Risk Equation, describing how it should be used in audit
planning.
Audit risk comprises the risk of material misstatement, control risk and detection risk. This
can be shown in equation as:
Audit risk= Inherent risk* Control Risk* Detection Risk
The auditor’s objective is to identify and assess the material misstatement through
understanding the entity and its environment. Misstatements can arise from fraud and
error. The misstatements leads to inherent risk and control risk. Hence auditor should plan
following things before starting audit procedure to mitigate the risk. In order to identify
the inherent risk, an auditor should plan to see whether the accounting standard
has been properly followed or not. Furthermore, auditor should see the nature of
entity and nature of balances. Likewise, the control risk can be detected by
thorough understanding of the design and effectiveness of the internal controls.
To avoid detection risk auditor should reduce audit risk to low level by detecting
misstatements that exists and could be material. For this, sampling basis should
be avoided and should follow appropriate audit procedure.

Discuss the considerations which would determine whether an item is material in

relation to financial statements.
Materiality by size
0.5-1% revenue
5-10% profit before Tax
1-2% Total assets
Materiality by nature
Transactions with directors
Going concern issues
Debt covenants

Discuss the validity of the statement that “materiality limits should be set at the
planning stage of the audit and should be rigidly adhered to throughout the
audit”.
Materiality limits should be set at the planning stage of the audit and should be rigidly
adhered to throughout the audit. This is because, the audit procedure is incomplete if
auditor doesn’t determine the materiality of the client. If not planned at beginning, the
materially important data or facts may be ignored while less important matters would be
detailedly investigated and evaluated. Such omission leads to detection risk in the audit
procedure leading to different opinion of auditor in financial statements prepared. For
determining the materiality limits, ISA 320 recognizes the threshold guide for planning audit
procedure. Material by size has the starting points are 0.5-1% of revenue, 5-10% of profit
before tax and 1-2% of the total assets. Similarly, some items may not be financial concern
but material by nature. Examples include misstatements affecting compliance, debt
covenants and regulations, or transactions with directors regarding salaries or personal use
of assets.

Financial ratios
Profitability Ratios:
Gross profit margin = Gross profit/Sales revenue *100%
Operating Profit margin = (Operating Profit or PBIT)/Sales revenue *100%
Liquidity ratios:
Receivable collection days = Receivables/ credit Sales *100%
Payables payment days = payables/ Credit purchase * 100%
Inventory holding period = Inventory/ Cost of Sales * 100%
Asset turnover ratio = Revenue/ Capital Employed or Revenue/Net Assets
Current Ratio = current Assets/ currents liabilities
Quick ratio = (Currents assets – inventories)/Current liabilities
Interest coverage ratio = PBIT/Interest Expenses

Investor’s ratios
ROCE = PBIT/Capital Employed*100%
ROE = PAT/ Equity *100%
Debt : Equity ratio = Total Liabilities/Total Equity