1. Audit Risk
Audit risk is the risk that an auditor expresses an inappropriate opinion when the financial statements are materially misstated. This is a key focus for auditors, as their objective is to reduce this risk to an acceptably low level.
Audit risk is made up of two main components:
- Risk of Material Misstatement: The risk that the financial statements contain material misstatements before the audit begins.
- Detection Risk: The risk that the auditor's procedures will fail to detect a material misstatement.
The relationship is multiplicative: Audit Risk = Risk of Material Misstatement x Detection Risk. This means if the risk of material misstatement is high, the auditor must reduce the detection risk by performing more rigorous procedures.
Components of Risk of Material Misstatement
This risk is further broken down into two components:
- Inherent Risk: The susceptibility of an account or transaction to misstatement, assuming there are no related controls. Factors like complex accounting treatments, the nature of the industry, or a balance's susceptibility to theft can increase inherent risk.
- Control Risk: The risk that the client's internal controls will fail to prevent, detect, or correct a material misstatement in a timely manner.
Exam Strategy: Distinguishing Audit Risk from Business Risk
In exam questions, it's crucial to identify and explain audit risks, not business risks. A business risk is a threat to the company's profitability or operations (e.g., losing a major customer). An audit risk is a threat that the financial statements will be materially misstated (e.g., trade receivables are overstated because a customer is struggling to pay).
Always link your identified risk back to a specific area of the financial statements being over or understated, or a disclosure being inadequate. Avoid explanations that only focus on the company's operational problems.
2. Materiality
Materiality is a cornerstone of auditing. A misstatement is considered material if it could reasonably be expected to influence the economic decisions of users based on the financial statements. It is a matter of professional judgment and is assessed based on both size and nature.
How Materiality is Determined
Auditors use quantitative benchmarks as a starting point for determining materiality, such as:
- 5-10% of profit before tax.
- 1-2% of total assets.
- 0.5-1% of revenue.
However, an item can also be material by its nature, regardless of its size. Examples include misstatements that:
- Affect compliance with regulations or debt covenants.
- Turn a profit into a loss.
- Relate to director transactions or other sensitive disclosures.
Performance Materiality
Auditors also set performance materiality at a level lower than overall materiality. This is done to reduce the probability that the sum of uncorrected and undetected misstatements, when aggregated, exceeds the overall materiality for the financial statements. This ensures that the audit is thorough enough to catch smaller misstatements that could become material in combination.
3. Risk Assessment and Professional Skepticism
Auditors perform risk assessment procedures to gain an understanding of the client and its environment, identify risks, and plan their audit. These procedures include inquiries with management, analytical procedures, observation, and inspection of documents. The goal is to identify risks of material misstatement before the audit work begins.
The Power of Professional Skepticism
Professional skepticism is a fundamental attitude for auditors. It requires a questioning mind and a critical assessment of all audit evidence. Auditors should not simply accept management's explanations at face value. For example, if management claims a receivable is fully recoverable despite a long history of non-payment, an auditor should seek additional evidence, such as post-year-end cash receipts or correspondence from the customer, to corroborate management's assertion. This helps prevent being misled by management bias and ensures the audit opinion is based on reliable evidence.
Analytical Procedures
Analytical procedures are a powerful tool used at all stages of the audit. They involve analyzing plausible relationships between financial and non-financial data to identify unusual fluctuations or trends. These procedures can help:
- Identify areas where misstatements are likely to exist (preliminary stage).
- Gather substantive evidence to test account balances (substantive stage).
- Form an overall conclusion on the financial statements (final stage).
Test Your Understanding Questions and Solutions
Your firm Wimble & Co has recently accepted appointment as auditor of Murray Co (a manufacturer of sports equipment).
Having sold your shares in Murray Co, you have been assigned as audit manager and you have started planning the audit (although you were an employee of Murray Co, this was many years ago and you did not have any involvement in the preparation of the financial statements). You have held a meeting with the client and have ascertained the following:
Murray Co manufactures sports equipment. Most items of equipment, such as tennis rackets, hockey sticks and goals, take less than one day to manufacture. Murray Co's largest revenue generating product, ergometers (rowing machines), takes up to one week to manufacture. Murray Co refurbished the assembly line for the ergometers during the year. Murray Co uses a third party warehouse provider to store the manufactured ergometers and approximately one quarter of the other equipment.
Historically, Murray Co has only sold to retailers. For the first time this year, Murray Co has made sales directly to consumers, via a new website. The website is directly linked to the finance system, recording sales automatically. Website customers pay on ordering. The website development costs have been capitalised. This initiative was implemented to respond to market demands, as retailer sales have fallen dramatically in the last two years. Some of Murray Co's retail customers are struggling to pay their outstanding balances. Several of the sales team were made redundant last month as a result of the falling retailer sales.
Murray Co is planning to list on the stock exchange next year.
Required:
Using the information provided, describe SIX audit risks and explain the auditor's response to each risk in planning the audit of Murray Co.
Solution:
| Audit Risk | Auditor's Response |
|---|---|
| New Audit Client: There is a lack of cumulative audit knowledge, increasing detection risk. | More time and resources should be spent on understanding the company. Opening balances should be agreed to prior year financial statements, and the previous auditor should be contacted for working papers. |
| Third-Party Warehouse: It may be difficult to obtain sufficient evidence over the quantity and condition of inventory, increasing detection risk. | Attend the inventory count at the third-party warehouse. Obtain external confirmation from the third party and inspect reports from their auditors on controls over inventory. |
| Work in Progress (WIP): Ergometers take time to manufacture, creating a material WIP balance. The valuation and quantity of WIP are complex and subjective. | Assess the reasonableness of the client's percentage of completion basis. Agree the WIP calculation to supporting documentation like purchase invoices and payroll records. |
| Website Development Costs: Capitalized development costs may not meet the criteria under IAS 38, leading to an overstatement of intangible assets. | Review a breakdown of the expenditure to ensure only costs that meet the capitalization criteria are included. The balance should be expensed. |
| New Website Sales: The new website is linked directly to the finance system. There is a risk of incompleteness of revenue if the system fails to record all sales. | Perform extended controls testing on the sales cycle. Use test data to confirm sales are automatically transferred. Perform detailed testing on completeness of income. |
| Falling Retailer Sales & Redundancies: This could indicate a material uncertainty over going concern. Additionally, a redundancy provision may be required under IAS 37, but could be understated. | Perform a detailed going concern review of cash flow forecasts. Discuss the redundancy program with management and review post-year-end bank statements for payments to staff. |
| Struggling Retail Customers: Outstanding balances may be irrecoverable debts, leading to an overstatement of receivables and an understatement of the irrecoverable debt allowance. | Perform extended post-year-end cash receipts testing. Review the aged receivables ledger for long outstanding debts and discuss the adequacy of the allowance with management. |
| Planned Stock Exchange Listing: This increases the risk of management manipulating the financial statements to show a more favorable position (e.g., overstating assets and profits). | Increase the level of professional skepticism. Plan and perform procedures to ensure judgmental areas and accounting estimates are reasonable and can be justified. Give special consideration to sales cut-off. |
Draft Statement of financial position as at 31 December 20X4
Draft Statement of profit or loss for the year ended 31 December 20X4
[...financial statements redacted for brevity...]
Solution:
| Analytical Procedure Finding | Audit Risk |
|---|---|
| Revenue has increased by 12% despite falling retailer sales. | Revenue may be overstated, possibly in an attempt to manipulate the financial statements ahead of the stock exchange listing. |
| Gross margin has increased from 12.8% to 15.5%. | This could be due to higher margins on new direct-to-consumer sales, but may also indicate overstated revenue or an understatement of cost of sales. |
| Operating expenses have not moved despite an increase in revenue and cost of sales. | The operating expenses may be understated, or the prior year figure has been incorrectly presented. |
| The inventory holding period has increased from 28 days to 41 days. | With falling retailer sales, this could mean inventory is slow-moving or obsolete and may be overstated on the balance sheet. |
| The receivables collection period has increased from 20 to 34 days. | This is inconsistent with a new direct sales channel with immediate payment and indicates that retail customers are struggling to pay. Receivables may be overstated and the allowance for irrecoverable debts understated. |
You are an audit senior at JPR Edwards & Co and you are currently planning the audit of Hook Co for the year ending 30 September 20X5. Your firm was recently appointed as auditor after a successful tender to provide audit and tax services. JPR Edward & Co were asked to tender after the lead partner, Neisha Selvaratalm, met Hook Co's CEO, Taylor Tucker, at a charity cricket match. Hook Co was unhappy with the previous auditors as it was felt the audit did not add much value to the company.
Hook Co manufactures electrical goods such as MP3 players, smartphones and personal computers for larger companies with established brands. Its key client, which represents 70% of its revenue, was the market leader in smartphones and MP3 players last year with 60% market share.
Hook Co uses a number of suppliers to source components for its products. Most suppliers are based in the UK, however microchips are imported from a number of overseas suppliers. Hook Co's products are assembled and packaged in one factory in the UK before being distributed to customers across the UK. The work-in-progress balance is expected to be material at the year end.
During the year, Hook Co started developing smartphone applications. $1 million has been spent on an application called 'snore-o-meter' which allows users to record the sounds they make while they are asleep. There was a technical difficulty in production which meant the launch of 'snore-o-meter' has been delayed from June to October 20X5.
To fund the expansion into smartphone applications Hook Co is seeking a listing on the London Stock Exchange in the fourth quarter of the year.
Required:
Using the information provided, describe FIVE audit risks and explain the auditor's response to each risk in planning the audit of Hook Co.
Solution:
| Risk and Explanation | Effect on Audit Approach |
|---|---|
| New Audit Client: Lack of prior knowledge increases detection risk and the risk of misstatement in opening balances. | Spend more time gaining an understanding of the client. Agree opening balances to prior year financial statements and contact the previous auditor for professional clearance and working papers. |
| Material Work-in-Progress (WIP): The valuation of WIP is subjective and complex, increasing the risk of overstatement of inventory. | Allocate appropriate time to attending the inventory count. Discuss the percentage of completion basis with management and agree the WIP calculation to supporting documentation. |
| Fast-Paced Industry: The electrical goods market is rapidly changing, so products could become obsolete, risking overstatement of inventory. | Review the aged inventory listing for old items and compare the allowance for write-downs to Net Realizable Value (NRV). |
| Reliance on Key Client: The key client represents 70% of revenue, creating a going concern risk if the contract is lost. This may lead to inadequate disclosures of material uncertainties. | Review contracts and correspondence from the key customer. Assess the impact on Hook Co's financial position if the contract is not renewed and evaluate the adequacy of going concern disclosures. |
| Capitalized Development Costs: A significant amount was spent on developing a smartphone app. There is a risk that research costs were incorrectly capitalized, leading to an overstatement of intangible assets. | Inquire about how the company determined the criteria for capitalization under IAS 38. Perform procedures to ensure that only eligible costs were capitalized and the balance was expensed. |
| Planned Stock Exchange Listing: This provides an incentive for management to "window dress" the accounts, increasing the risk of manipulation (e.g., overstating assets and profits). | Increase professional skepticism. Plan procedures to ensure judgmental areas and estimates are reasonable. Give special consideration to sales cut-off testing. |
Question: Define materiality and explain how the level of materiality is assessed.
Solution:
Materiality refers to misstatements or omissions that could reasonably be expected to influence the economic decisions of users of the financial statements. It is a matter of professional judgment and is assessed based on both the size (quantitative) and nature (qualitative) of the misstatement.
For quantitative assessment, auditors often use benchmarks such as 5-10% of profit before tax or 1-2% of total assets. For qualitative assessment, an item may be material regardless of its size if it affects compliance with regulations, turns a profit into a loss, or relates to sensitive transactions.
The auditor must also consider that multiple small, individually immaterial misstatements could be material in aggregate. For this reason, auditors set a lower threshold called performance materiality for testing individual transactions and balances.
You have received the latest management accounts from your client, Esperence Co, to help with your risk assessment for the forthcoming audit. The management accounts show actual results for the year to date, January to October inclusive. In October, Esperence Co received a claim from a customer as a result of a defective product.
Question 1: Which of the following is an example of an audit risk for Esperence Co?
- A. The client is being sued by a customer for a defective product and if the claim is successful, the compensation awarded is likely to be significant
- B. The client is being sued by a customer for a defective product. The publicity of the case could damage the company's reputation
- C. The client will have to spend a significant amount of money on improving its quality control procedures to avoid the defects occurring again
- D. Provisions may be understated if the probable payment resulting from the court case is not recognised as a liability in the financial statements
Solution:
D. Options A, B, and C are business risks. An audit risk must be described in terms of a risk of material misstatement in the financial statements, which in this case is the understatement of a provision.
Question 2: Which of the following is the correct formula for calculating the payables payment period using the management accounts of Esperence Co?
- A. Payables/Cost of sales x 304
- B. Payables/Cost of sales x 365
- C. Payables/Revenue x 304
- D. Payables/Revenue x 365
Solution:
A. The correct formula is Payables / Purchases x number of days. As purchases are not available, cost of sales is a suitable substitute. The period is 10 months (Jan-Oct) which is 304 days (30.4 days/month). Thus, option A is the most appropriate.
Question 3: Which of the following is not an analytical procedure?
- A. Calculation of gross profit margin and comparison with prior year
- B. Recalculation of a depreciation charge
- C. Comparison of revenue month by month
- D. Comparison of expenditure for current year with prior year
Solution:
B. Recalculation is a substantive test of detail, not an analytical procedure. Analytical procedures evaluate relationships between data.
Question 4: Which of the following is not a ratio?
- A. Gross profit margin
- B. Acid test
- C. Inventory turnover
- D. Revenue growth
Solution:
D. Revenue growth is a trend or rate of change, not a ratio between two different balances.
Question 5: You have used the management accounts to calculate the gross profit margin and found it to be higher than the prior year figure. Which of the following would provide a possible explanation?
- A. Sales prices have been reduced to increase sales volumes
- B. Prices charged by suppliers have increased but the company has not increased sales prices to customers to cover the increased costs
- C. Closing inventory has been overvalued
- D. Administration expenses have decreased
Solution:
C. If closing inventory is overvalued, a larger figure is deducted from the cost of sales, resulting in a lower cost of sales and a higher gross profit margin. Options A and B would both cause the gross profit margin to fall, and D would not affect gross profit.
You are the audit manager responsible for planning the audit of Fremantle Co. The draft financial statements show profit before tax of $3m and total assets of $50m. You have held a planning meeting with the client and have performed preliminary analytical procedures on the draft financial statements. You are currently assessing preliminary materiality for the audit and performing further risk assessment procedures.
Question 1: Which of the following statements is false in relation to materiality?
- A. Materiality can be assessed by size or nature
- B. A balance which is omitted from the financial statements cannot be material
- C. Materiality is a matter of professional judgment for the auditor
- D. There is an inverse relationship between risk and materiality. If audit risk is high, the materiality level set by the auditor will be lower
Solution:
B. A balance which is omitted from the financial statements can be a material misstatement if its omission could influence a user's decision. Omissions are explicitly included in the definition of a misstatement.
Question 2: Which of the following procedures are NOT required to be performed in accordance with ISA 315 to identify risks of material misstatements?
- A. Inspection
- B. Observation
- C. External confirmation
- D. Enquiry
Solution:
C. External confirmation is typically a substantive procedure, not a risk assessment procedure. The other three options are all required risk assessment procedures.
Question 3: Based on the above draft figures, what would be an appropriate level at which to set preliminary materiality?
- A. $150,000 for the statement of profit and loss and $500,000 for the statement of financial position
- B. $500,000 for the statement of profit and loss and $150,000 for the statement of financial position
- C. $1,500 for the statement of profit and loss and $50,000 for the statement of financial position
- D. $50,000 for the statement of profit and loss and $1,500 for the statement of financial position
Solution:
A. Preliminary materiality is calculated based on professional judgment, but common benchmarks are 5% of Profit Before Tax (PBT) and 1% of Total Assets. PBT is $3m, so 5% is $150,000. Total Assets are $50m, so 1% is $500,000. Since materiality is often set lower for the P&L, A is the most appropriate option.
Question 4: Performance materiality should be used by the auditor when performing substantive testing during the audit. Which of the following best describes performance materiality?
- A. The maximum amount of misstatement the auditor is willing to accept
- B. The amount at which the auditor deems the misstatement to be trivial
- C. An amount which could influence the economic decisions of the users taken on the basis of the financial statements
- D. An amount set below materiality for the financial statements as a whole to reduce, to an acceptably low level, the risk that misstatements could be material in aggregate
Solution:
D. This is the official definition of performance materiality from ISA 320.
Question 5: Professional scepticism must be applied by auditors during the audit. Which of the following is NOT an application of professional scepticism?
- A. A critical evaluation of the evidence
- B. An open and questioning mind
- C. The auditor should not believe anything the client tells them
- D. The auditor must be alert to fraud and error
Solution:
C. Professional skepticism is about having a questioning mind and critically assessing evidence, but it does not mean complete distrust. The auditor should not assume dishonesty but should always be alert to potential risks.