AA - Planning & risk assessment

Identifying Audit Risks

TERMINOLOGY USED:

Audit risk is the risk of the auditor giving an inappropriate opinion on the financial statements. For example,
stating the financial statements are true and fair when there is a material misstatement uncorrected.

Audit risk = Inherent risk * Control risk * Detection risk

ISA 315: Auditors required to perform risk assessment procedures.

ISA 200: Auditors must apply ‘professional scepticism’ during the audit

Professional scepticism is an attitude that includes a questioning mind, being alert to conditions which may
indicate possible misstatement due to error or fraud, and a critical assessment of audit evidence.

Risk assessment includes two main pieces of work:

1) Understanding the entity and its environment

2) Using analytical procedures.

UNDERSTANDING THE ENTITY AND ITS ENVIRONMENT:

The process of understanding includes the following:

- Understanding the industry and other external factors;

- Laws and regulations affecting the entity;
- Organisational structure;
- Accounting policies that company follows;
- Client business plan and risks;
- Financial performance;
- Internal controls.
Three main methods of gathering information about the client are:
1) Enquiry;
2) Observation;
3) Inspection.

The four main sources of information are:

a) Within the audit firm (previous years workings, discussions with audit partner and manager);
b) From external sources (companies house, internet and trade press, industry surveys, credit reference
agencies);
c) From the client (discussions with management, observation of procedures, website, brochures);
d) From the individual auditor.

USING ANALYTICAL PROCEDURES:

Analytical procedures are defined as:

1) Evaluations of financial information through analysis of plausible relationships among both financial and
non-financial data (ISA 520).
2) Comparing financial and non-financial data to understand changes.

Note: Analytical procedures are used on planning stage, substantive testing stage and completion and review
stage of the audit.

The purpose of analytical procedures at the planning stage is to understand the business the client
operates, identify unusual balances, transactions and events, and identify potential material misstatements.

Ratios can be categorised to review the following:

1) Profitability ratios:

Gross profit PBT

Gross profit margin = * 100% Net margin = * 100%
Revenue Revenue

2) Efficiency ratios:

Receivables Payables
Receivable days = * 365 days Payable days = * 365 days
Revenue Purchases

Inventory
Inventory days = * 365 days
Cost of sales
3) Liquidity ratios:

Current assets Current assets - Inventory

Current ratio = Quick ratio =
Current liabilities Current liabilities

4) Return ratios:

Borrowings
Debt
Gearing ratio = =
Equity Share capital and reserves

Note: Comparison of current year ratios to previous year, budgets and averages helps to identify unusual
differences which could be the result of a material misstatement.