Risk

AUDIT AND ASSURANCE

Saroj Dangal
 Audit Risk
The risk that the auditor expresses an inappropriate opinion when the
financial statements are materially misstated [ISA 200 Overall
Objectives of the Independent Auditor and Conduct of Audit in
accordance with ISA]

Saroj Dangal
 Misstatements
A difference between the amount, classification, presentation, or
disclosure of a reported financial statement item and the amount,
classification, presentation, or disclosure that is required for the item
to be in accordance with the applicable financial reporting framework.
Misstatements can arise from error or fraud.’
[ISA 450 Evaluation of Misstatements Identified During The Audit]

Types of Misstatements

• Factual Misstatements
• Judgmental Misstatements
• Projected Misstatements

Saroj Dangal
 IMPORTANCE OF AUDIT RISK TO AUDITORS

• Audit risk is fundamental to the audit process because auditors cannot

and do not attempt to check all transactions.

• Auditors should direct audit work to the key risks (sometimes also
described as significant risks), where it is more likely that errors in
transactions and balances will lead to a material misstatement in the
financial statements.

• It would be inefficient to address insignificant risks in a high level of

detail, and whether a risk is classified as a key risk or not is a matter of
judgment for the auditor.

Saroj Dangal
 RISK-EXPLANATION(ISA 200)
“ Inherent risk is the susceptibility of an assertion about
a class of transaction, account balance or disclosure to
misstatement that could be material, before
consideration of any related controls”

“Control risk is the risk that a misstatement that could

occur and that could be material will not be prevented,
or detected and corrected on a timely basis by the
entity’s internal controls”

“Detection risk is the risk that the procedures performed

by the auditor to reduce audit risk to an acceptably low
level will not detect a misstatement that exists and that
could be material”
Saroj Dangal
 RISK-EXPLANATION(ISA 200)

“Sampling Risk is the risk that the auditor’s conclusion

based on a sample is different from the conclusion that
would be reached if the whole population was tested”

“Non-Sampling Risk is the risk that the auditor’s

conclusion is in appropriate for any other reason, e.g.
human error, application of inappropriate procedures,
failure to recognize a material misstatement

Saroj Dangal
 PROFESSIONAL SCEPTICISM(ISA 200)
“An Attitude that includes a questioning mind, being
alert to conditions which may indicate possible
misstatement due to fraud or error, and a critical
assessment of audit evidence”

Professional skepticism requires the auditor to be

alert to:
• Audit evidence that contradicts other evidence
• Information that brings into question the
reliability of documents and responses to
enquiries to be used as audit evidence
• Conditions that may indicate possible fraud
• Circumstances that suggest the need for audit
procedures in addition to those required by ISAs
Saroj Dangal
 MATERIALITY

“Misstatements, including omissions, are considered to

be material if they individually or in the aggregate
could reasonably be expected to influence the economic
decisions of users taken on the basis of financial
statements”

[ISA 320 Materiality in Planning and Performing an Audit]

• Significance of Materiality in Audit??

• Materiality Determination??
• Material By Size
• Material By Nature
Saroj Dangal
 MATERIAL BY SIZE vs NATURE

MATERIAL BY SIZE MATERIAL BY NATURE

0.5%-1% of REVENUE REGULATORY REQUIREMENTS

5%-10% of PROFIT BEFORE TAX DEBT COVENANTS

1% -2% of TOTAL ASSETS REPORTED PROFIT INTO LOSS

NET ASSETS TO NET LIABILITY POSITION

TRANSACTIONS WITH DIRECTORS

DISCLOSURES RELATING TO POSSIBLE

LITIGATION CLAIMS OR GOING CONCERN
ISSUES

Saroj Dangal
 PERFORMANCE MATERIALITY
“The amount(s) set by the auditor at less than materiality
for the financial statements as a whole to reduce to an
appropriately low level the probability that the aggregate
of uncorrected and undetected misstatements exceeds
materiality for the financial statements as a whole

and

the amount(s) set by the auditor at less than the

materiality level(s) for particular classes of transactions,
account balances or disclosures.”

This reduces the risk that the auditor will fail to identify
misstatements that are material when added together
Saroj Dangal
 Materiality-Example
• CCA Limited has been an audit client of yours for several years. Over the
last Three years they have been making recurring losses and you are
auditing the financial statements for the year ended 31 Sep 2010 which
show a pre-tax profit of £25,000. You have determined a financial
statement materiality level of £50,000.

• During the course of your audit you have discovered a purchase invoice
amounting to £40,000 which was received on 15 December 2010 but
related to purchase received by CCA on 25 Sep 2010 and has been dated
31 Sep 2010. The invoice has not been provided for in the financial
statements

• You can see that CCA £25,000 profit would turn into a £15,000 loss if this
invoice is not adjusted for in the financial statements, despite it being
under the original materiality level calculated at the planning stage. The
fact that this would completely change the picture presented in the
financial statements would mean this should be adjusted for as it is
material by nature
Saroj Dangal
 ISA 315 Identifying and Assessing the Risks of
Material Misstatement Through Understanding
the Entity and Its Environment

• The auditor shall perform risk assessment procedures in

order to provide a basis for the identification and assessment
of the risks of material misstatement

• The auditor is required to obtain an understanding of the

entity and its environment, including the entity’s internal
control systems

• The auditor shall identify and assess the risks of material

misstatement, and determine whether any of the risks
identified are, in the auditor’s judgement significant risks.
This is in order to provide a basis for designing and
performing further audit procedures. Saroj Dangal
 RISK ASSESSMENT PROCEDURES

• Making inquiries of management and others within the entity Auditors

must have discussions with the client’s management about its objectives and
expectations, and its plans for achieving those goals

• Analytical procedures Analytical procedures performed as risk assessment

procedures should help the auditor in identifying unusual transactions or
positions. They may identify aspects of the entity of which the auditor was
unaware, and may assist in assessing the risks of material misstatement in
order to provide a basis for designing and implementing responses to the
assessed risks

• Observation and inspection Observation and inspection may also provide

information about the entity and its environment. Examples of such audit
procedures can potentially cover a very broad area, including observation or
inspection of the entity’s operations, documents, and reports prepared by
management, and also of the entity’s premises and plant facilities
Saroj Dangal
 Analytical Procedures

• 'Evaluations of financial information through analysis of plausible relationships

among both financial and non-financial data and investigation of identified
fluctuations, inconsistent relationships or amounts that differ from expected
values.' [ISA 520 Analytical Procedures, 4]

• Use of Analytical Procedures

 ISA 315 requires the auditor to perform analytical procedures as
risk assessment procedures in order to help the auditor to obtain
an understanding of the entity and assess the risk of material
misstatement.
 ISA 500 Audit Evidence allows the auditor to use analytical
procedures as a substantive procedure during the final audit to
help detect misstatement.
 In addition, ISA 520 requires the auditor to use analytical
procedures at the completion stage of the audit when forming
an overall conclusion as to whether the financial statements are
consistent with the auditor’s understanding of the entity.
Saroj Dangal
 KEY RATIOS UNDER ANALYTICAL PROCEDURES

TYPE KEY RATIOS

GROSS PROFIT MARGIN

PROFITABILITY
NET PROFIT MARGIN

RECEIVABLE DAYS

EFFICIENCY INVENTORY DAYS

PAYABLE DAYS

CURRENT RATIO

LIQUIDITY QUICK RATIO

GEARING

RETURN ROCE

Saroj Dangal
 UNDERSTANDING AN ENTITY

Information Information
from your from External
firm Sources

Information
Information
from the
from You
client

Saroj Dangal
 Identification and assessment of significant risks
and the risks of material misstatement, ISA 315
 Whether the risk is a risk of fraud.

 Whether the risk is related to recent significant economic,

accounting or other developments, and therefore requires specific
attention.

 The complexity of transactions.

 Whether the risk involves significant transactions with related

parties.

 The degree of subjectivity in the measurement of financial

information related to the risk, especially those measurements
involving a wide range of measurement uncertainty.

 Whether the risk involves significant transactions that are outside

the normal course of business for the entity, or that otherwise
Saroj Dangal

appear to be unusual.
 Questions Dealing Approach
Audit Risk (1 mark)
 Identify the Risk from Scenario (0.5 marks)

 Explain the risk (0.5 Marks)

 Refer to ISA, IAS, Accounting issues, C.G. Issues or any other relevant
reference.

 Implication on FS (Under/overstate, Assertions , Inherent/Control,

Disclosures) (Mentioning Implication avoids Business Risk(ROMM or detection
risk is must)

Response (1 Mark)
 Start with Technical word (Such as Enquire, Discuss, Inspect, Observe, Obtain,
Review etc.)

 Refer to document or person (such as management, breakdown of cost, Post year

end sales etc.)

 Clarify the reason of picking document (such as for the rational, ensure
Saroj Dangal
compliance with ISA etc.)
 Questions Dealing Approach
Identification of risk NOT Audit risk (business
from the scenario Audit risk explanation risk)
Customers are Receivables may be Irrecoverable debts may
struggling to pay debts. overstated if irrecoverable arise reducing the profit
debts are not written off. of the company.
The client operates in Inventory may be overstated if Inventory may have to be
a fast paced industry. the inventory is obsolete and written off reducing the
net realizable value is lower profit of the company.
than cost.
Revenue is falling due If other factors are present, Falling revenue will result
to recession. The cash this could mean the company in reduced profit and
flow forecast shows is unable to continue to trade possible going concern
negative cash flows for for the foreseeable future and issues.
the next going concern disclosures may
12 months. be required. There is a risk
that adequate disclosure is
not made. Saroj Dangal
 Questions Dealing Approach
Audit risk Relevant response Irrelevant response Explanation

Customers are struggling to Inspect after date cash Obtain the receivables listing The risk identified is
pay debts. receipts from customers to and cast it to verify overvaluation. Obtaining the
Receivables may be see if paid post year-end arithmetical accuracy. listing does not provide
overstated if irrecoverable proving the debt is evidence that the debts are
debts are not written off. appropriately valued. appropriately valued.
Review the aged
receivables listing for old
debts which may not be
recoverable and discuss the Obtain external confirmation External confirmation is
need for an allowance to be from customers to confirm providing evidence of
made with management. existence. existence but not valuation.

The company should improve This is a client response not

its credit control procedures. an auditor response.

The client operates in a Obtain the aged inventory The company should This is a client response not
fast paced industry. listing and review for old discount the inventory in an auditor response.
Inventory may be items. Discuss with order to sell it.
overstated if obsolete management the need for Saroj Dangal

items are not written off. these to be written down in

the financial statements.
 Practice Question

You are an audit supervisor of Earl & Co and are planning the audit of Darjeeling Co for the year
ending 30 September 20X8. The company develops and manufactures specialist paint products
and has been a client of your firm for several years. The audit manager has attended a planning
meeting with the finance director and has provided you with the following notes of the meeting
and financial statement extracts. You have been asked by the audit manager to undertake
preliminary analytical procedures using the financial statement extracts.
Planning meeting notes
During the year Darjeeling Co has spent $0.9m, which is included within intangible assets, on the
development of new product lines, some of which are in the early stages of their development
cycle. Additionally, as the company is looking to expand production, during the year it purchased
and installed a new manufacturing line. All costs, incurred in the purchase and installation of that
asset, have been included within property, plant and equipment. These capitalised costs include
the purchase price of $2.2m, installation costs of $0.4m and a five‐year servicing and
maintenance plan costing $0.5m. In order to finance the development projects and the new
manufacturing line, the company borrowed $4m from the bank which is to be repaid in
instalments over eight years and has an interest rate of 5%. Developing new products and
expanding production is important as the company intends to undertake Saroja stock exchange listing
Dangal

in the next 12 months.

The company started a number of initiatives during the year in order to boost revenue. It
offered extended credit terms to its customers on the condition that their sales order quantities
were increased.

In addition, Darjeeling Co made an announcement in October 20X7 of its ‘price promise’: that it
would match the prices of any competitor for similar products purchased. Customers who are able
to prove that they could purchase the products cheaper elsewhere are asked to claim the
difference from Darjeeling Co, within one month of the date of purchase of goods, via its website.
The company intends to include a refund liability of $0.25m, which is based on the monthly level
of claims to date, in the draft financial statements.
The finance director informed the audit manager that a problem arose in June 20X8 in relation to
the mixing of materials within the production process for one particular product line. A number of
these faulty paint products had already been sold and the issue was identified following a number
of complaints from customers about the paint consistency being incorrect. As a precaution,
further sales have been stopped and a product recall has been initiated for any of these specific
paint products sold since June.
Management is investigating whether the paint consistency of the faulty
Saroj products
Dangal can be rectified
and subsequently sold.
 Financial statement extracts for year ending 30
September
Forecast Actual
20X8 20X7
$000 $000
Revenue 19,850 16,990
Cost of sales (12,440) (10,800)
––––––– –––––––
Gross profit 7,410 6,190
––––––– –––––––
Inventory 1,850 1,330
Trade receivables 2,750 1,780
Bank (810) 560
Trade payables 1,970 1,190

(a) Using the information provided and the ratios calculated, describe EIGHT audit
risks and explain the auditor’s response to each risk in planning the audit of
Darjeeling Co.
Note: Prepare your answer using two columns headed Audit risk and
Auditor’s response respectively. Saroj(16
Dangalmarks)
Audit Risk Audit response
D. has spent 0.9m within intangible assets, some of Obtain breakdown of 0.9m and assess whether they
which are in early stages of development. satisfy capitalization criteria and request
According to IAS 38 ‘Intangible assets’ only those management to treat 0.9m in accordance with IAS
cost which satisfy the development criteria should 38.
be capitalized.
There is possible risk that if all cost dose not satify
capitalization criteria then intangible assets might
be overstated and expenses understated.

New machine has been purchased and installed, cost Enquire with management about treatment of 0.5m
comprise of purchase price, installation cost, and if it is inappropriate request management to
service and maintenance cost. make necessary adjustment.
IAS 16 requires that only purchase price and directly Request Management to book 0.5m over 5year as
attributable cost should be capitalized. expenses.
As maintenance cost does not satisfy the criteria,
there is indication that PPE and profit has been
overstated, expenses understated.
Review the treatment of 5m loan and ensure it has
Company has borrowed 5m loan. been properly splited between Current and non-
This loan needs to be correctly split between current liabilities. If it has not been done request
current and non-current Liabilities. management to make necessary adjustment.
There is possible risk if the proper split is not made Saroj Dangal

then Current and non-current liabilities might be Obtain breakdown of 5m loan and ensure that the
misstated. repayable amount with a year has been shown in
Audit Risk
Loan has an interest rate of 5%.
This 5% amount should be recognized in PL as finance
expenses.
It is probable that management might have missed this
treatment and as a result Interest expenses might be
understated and profit overstated.
Audit response
Discuss with management if they have recognized interest
expenses corresponding the Loan and if they have not
recognized then request them to book it as interest
expenses.

Company is intending to undertake stock listing in next 12 Auditors should be aware and use their professional
months. skepticism on judgmental areas where the decisions are
For a company to be listed on a stock, they must have highly subjective and are likely to be manipulated by
strong position and performance. management.
There is possible risk that management might tend to
manipulate Assets and profit overstating it.
Company has extended its credit term as to increase Enquire with management whether they have recognized
revenue. additional provision to cover additional credit sales. If not
request them to book adequate provision.
Higher credit sales might require higher provision for bad
debt to be created.
If provision for bad debt is not adequate there is possible
risk that receivable might be overstated and provision
Understated.
Saroj Dangal
Audit Risk Audit response
Company have made price promise that it will Review if management have created sufficient
refund the differences in same product sold by its refund liabilities for 1 month period and if not
competitors if they have charged higher price. request to make necessary adjustment for
According to IFRS 15, revenue should not be adequate refund liabilities.
recognized unless all performance objectives are
satisfied and adequate refund liabilities should be
created for 1 month.
If it is not done there is possible risk that revenue
might be overstated and refund liabilities
understated.

There is problem in company’s product mixing
line. (Calculate Inventory holding period)
As number of complain are increasing the NRV of
product is likely to be lower and IAS 2 requires
inventory to be valued at lower of cost or NRV.
There is possible risk that Inventory and profit
might be overstated.
Review sample of post year-end sales to ensure
that NRV is higher than cost. If it is not the case
review accounting treatments of inventory and
request to make necessary adjustment.
Saroj Dangal
 Examiners Comment

Questions required candidates to identify and describe eight audit risks and to
explain the auditor’s response to each in planning the audit of Darjeeling Co.
Performance on this question was satisfactory. Marks were awarded for identification
of an audit risk (½ mark each), explanation of the audit risk (½ mark each) and an
appropriate auditor’s response to each risk (1 mark each). The scenario contained
more than eight risks so it was pleasing that most candidates planned their time
carefully and generally only attempted to list the required number of points. As in
previous diets, although candidates identified the risks, many candidates did not
adequately explain the risk. To explain the risk, candidates need to state the area of
the financial statements impacted with an assertion (for example cut‐off/valuation
etc), or a reference to over/under/misstated, or a reference to
inherent/control/detection risk.

Saroj Dangal
 Examiners Comment

For example, candidates often correctly identified that the company had made a price
promise to customers and therefore recognized a refund liability, this was awarded ½
mark for identification, however, no further credit was awarded for explanations
relating to the business implications of false claims. To be awarded the ½ explanation
mark candidates need to clearly state the audit implication, for example, that ‘profit
and the liability may be misstated’. Candidates should ensure that when identifying
audit risks they use the scenario fully and rather than listing generic risks they use the
detail provided. For example,service and maintenance costs had been included within
the cost of a new manufacturing line capitalized into property, plant and equipment.
The audit risk therefore related to the incorrect capitalization of the service and
maintenance costs and answers should have focused on this specific issue. However, a
significant number of candidates provided genericrisks and responses relating to
capital vs revenue expenditure. Candidate performance in relation to auditor’s
responses continues to be mixed. While an auditor’s response does nothave to be a
detailed audit procedure, rather an approach the audit team will take to address the
identified risk, the responses given were often too weak such as ‘discuss with
management’. This is not a sufficient response to deal with any identified audit risk
and candidates need to be able to use their knowledge of audit procedures to provide
a valid response which would adequately address the risk identified.
Saroj Dangal
 Chapter Objectives:

• Explain the need to plan and perform audit engagements with an

attitude of professional skepticism, and to exercise professional
judgment. [2]
• Explain the components of audit risk.
• Describe the audit risks in the financial statements and explain the
auditor's response to each risk. [2]
• Define and explain the concepts of materiality and performance
materiality. [2]
• Explain and calculate materiality levels from financial information. [2]
• Explain how auditors obtain an initial understanding of the entity, its
environment and the applicable financial reporting framework.
• Describe and explain the nature and purpose of analytical procedures
in planning. [2]
• Compute and interpret key ratios used in analytical procedures. [2]

Saroj Dangal
Thankyou.