Ahmed Mumtaz (ACCA Member)

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Audit Risk Question

How factor will affect

F/S
or
Disclosure notes
or
Basis of preparation

Response

Audit Risk Response

New Client
This is the 1st year audit firm have More time and resources will need to be
audited this client. devoted to obtaining an understanding of
the client at the start of the audit. More
There is a lack of cumulative audit substantive procedures will need to be
knowledge and experience increasing planned and performed and larger samples
detection risk. tested in order to lower detection risk.

Opening balances may be mis-stated as O/P balances will need to be agreed to the
audit firm did not conduct the audit last prior year signed financial statement. The
year. previous auditor could be contacted to
obtain relevant working papers.

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Inventory
Audit Risk Response
WIP
At the year-end it is anticipated that The percentage of completion basis should be
there will be significant levels of WIP, discussed with the client and assessed for
likely to constitute a material balance. reasonableness.

Determining the value and quantity of The WIP calculation should be agreed to
WIP is complex and the audit team may supporting documentation such as purchase
not be sufficiently qualified to assess the invoice for materials and timesheets and pay-roll
quantity and value of WIP. Thereby records for labor.
materially over/understating value of The overhead calculation should be recalculated
WIP in Statement of Financial Position. and reviewed for any non-production overheads
to ensure value of WIP as not been over/under
stated.
Obsolete inventory
Obsolete items may have not been Obtain the aged inventory listing and review for
written off. old items and inspect for the reasons why these
items have not been sold yet. This may indicate
If obsolete inventory is not written off signs of impairment. Discuss with management
then no impairment will be charged to the need for these to be written down in the F.S
Profit or Loss thus inflating Statement of to ensure value of inventory is not materially mis-
Profit or Loss and overstating inventory stated.
in Financial Position, thereby misleading
end user of Financial Statements.
3rd party warehouse
Inventory is stored at a 3rd party In-order to reduce detection risk over inventory
warehouse. quantities and condition that is stored at 3rd party
warehouse;
It may be difficult to obtain sufficient ➢ Attend the inventory count at the 3rd party
and appropriate evidence over the warehouses to review the controls in
quantity and condition of inventory held. operations.
There is increased detection risk over ➢ Inspect any reports produced by the auditor
completeness, existence and valuation of of 3rd party warehouses in relation to the
inventory. adequacy of controls over inventory.
➢ Obtain external confirmation from the 3rd
party regarding the quantity and condition of
the inventory.

Perpetual inventory
Increased risk of material mis-statement Assess the adequacy of internal controls around
related to the completeness, existence inventory records to determine whether the
and valuation of the inventory system, inventory records can be relied upon. Enquire
as some inventory could be lost due to with management the need for annual inventory
count.
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theft, fraud and may be some inventory
that has become obsolete has not been
counted for under current perpetual
system, if all inventory is not counted at
least once a year.
NRV vs. Cost
There is a risk that inventory is For the c/d inventory at the year end, establish
overstated in F.S as there may be some the lower of cost (by inspecting invoices) and NRV
items whose selling price is less than (by inspecting post year-end sales made) and
cost. compare with the figures provided by the client.
Investigate differences, evaluated the potential
Company might be facing problems in impact on the inventory value in Financial
selling items leading to increase in Statements.
inventory days from ‘x’ to ‘xx’ and
inventory turnover has fallen from ‘xx’ to
‘x’ which may suggest that inventory is
not valued at the lower of cost and NRV.
So Profit or Loss Statement could be
inflated as impairment need to be
charged and Financial Position
overstated, thereby misleading wide
range of users while making economic
decision.
Note:
inventory days are inversely
propotional to inventory
tunover.

Cost not up to-date

The current year raw costs for material Cost of material used for inventory valuation
are based on prices at least year old. should be compared to actual cost for an
appropriate sample of inventory items.
They should be based on the actual cost Investigate and resolve any significant differences
or reasonable average cost. If inventory and evaluate the potential impact on the
is valued on year old prices then there is inventory value in the F.Ss.
increased risk over valuation of
inventory due to fluctuation in prices
over the year, hence inventory may be
over/under valued in Statement of
Financial Position. So Financial
Statements won’t show true and fair
view to user of Financial Statements.

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Receivable
Audit Risk Response
Some retail customers are struggling to pay The auditors should carryout post year end
their outstanding balance, to client Co. testing and cut-off testing on receivable’s
balance to verify the accuracy of the year-end
Increased risk of over-valuation of balance
receivables………..(add any of the following
as per the case) The auditors should also review the aged
receivables listing to identify any balance that
Confirm factors from case; need writing off.
➢ …….. highlighted by considerable increase
of receivable balance compared to prior Allowance for receivables should be discussed
year. with management if it is considered
➢ ……. And concerns about the audit credit inadequate.
worthiness of some customers
➢ ……. Highlighted by considerable increase
of receivable days from ‘x’ to ‘xx’ days……
(Increasing the credit terms offered to
customers.)

Related Bonus
Audit Risk Response
Sales Related Bonus
A generous sales related bonus scheme Increased sales cut-off testing will be required to
has been introduced for the Company’s ensure sales are recorded in relevant accounting
salesmen. period.

This increased the risk of mis-statement Post year-end sales returns should be reviewed,
over the sales figures in Profit or Loss as as they may provide evidence of fake sales order
salesmen may manipulate sales to and ensure these sales have been reversed.
achieve/maximize bonus by generating
fake order or recording sales in wrong
accounting period. Resulting in material
mis-statement in Statement of Profit or
Loss.

Profit Related Bonus

There is a risk that revenue and costs The auditors need to maintain professional
have been deliberately misstated in F.Ss. scepticism throughout the audit and carry out
in order for the directors to meet the detailed cut-off testing on revenue and expenses
target profit of “x”, so as to get their to confirm that the figures are correct and are
bonuses. (window dressing) recorded in relevant accounting period.

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This is also indicated by the fact that the
directors……..(add bullet 1)

Confirm facts from case;

Anything that reduces expense or
increases revenue like
1. ....have changed the useful economic
life of plant and machinery from 3 to 5
years to reduce the deprecation
charge for the year…….. (add bullet 2)
(then relate it to profit then to bonus)
2. ……and hence inflate the profit fig. to
attain the minimum target figure.

Capitalization
Audit Risk Response
Development expenditure
In order to be capitalized it must meet all A breakdown of the development expenditure
of the criteria under IAS 38 Intangible should be reviewed and tested in detail to
assets. There is an increased risk over the ensure projects which meet the capitalization
classification of research and criteria are included as intangible assets, with
development expenditure, if research the balance being expensed.
expenditure is capitalized then it will not
be expensed out in profit or loss thus
inflating profit and over-valuing
intangible assets in Financial Positon.
Thereby misleading wide range of users
while making economic decision.

Revenue vs Capital
Expenditure Review a breakdown of the costs and agree to
There is an increased risk over the invoices to assess the nature of the expenditure.
classification of revenue and capital For capital expenditure agree to inclusion within
expenditure, if revenue expenditure is the assets register and if repairs agree to
capitalized then it will not be expensed expense in the SPL.
out in profit or loss thus inflating profit
and over-valuing assets in Financial
Positon. Thereby misleading wide range
of users while making economic decision.

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Difficult year
The auditors must discuss with directors
whether they believe that the Co. is still a going
concern in light flow forecast and budgets for
the forthcoming year and evaluate the
reasonableness of the assumptions used.
Listing on Stock Exchange
There is a risk that management have Plan and perform procedure to ensure
greater incentive to manipulate the accounting estimates and judgemental areas
results by adopting a more aggressive are reasonable.
approach in relation to accounting Maintain professional scepticism and alert to
estimates like increasing the useful life of the risks identified in order to achieve a
an asset. Thereby over-statement of successful listing.
assets and profits and under-statement of
Current year balance should be compared to
expenses and liabilities.
prior year to highlight any unusual trends.
Evaluate any assumptions made by
management in accounting estimate.
Provision
2 years guarantee on the beds gives rise Establish the basis of the amount provided for
to a provision, the measurement of which and assumptions made by the finance
involves a high degree of judgement and controller.
therefore carries a risk of mis-statement.
Random
A new accounting package was The new system will need to be fully
introduced. documented by the audit team including
The fact the two systems were not run in relevant controls. Testing should be performed
parallel increases the risk that errors to ensure the closing data on the old system
occurring during the changeover were not was correctly transferred as the opening data
highlighted and all areas of the financial on the new system and that transactions have
statements could potentially be affected. not been duplicated on both system and
therefore include twice.
The IT manager who developed the This audit team will need to ascertain from the
bespoke system left the company after 2 finance director how this risk of mis-statement is
months after the changeover and his being mitigated. During the audit the audit for
replacement is not due to start until just evidence of errors, particularly when testing
before the year end. transactions occurring b/w that interval.
Without an IT manager’s support in the
interim. Errors may occur and may not be
picked up due to lack of knowledge or
experience of the system. This could
potentially result in mis-statements in
many areas of financial statements.

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$1 million of equity finance and $2.5 The audit team must ensure the split of the
million of long-term loans has been raised equity finance is correct and that total financing
during the year. proceeds of $3.5 million were received.
The accounting treatment and disclosure Disclosures relating to the equity and loan
of these can be complex with the equity finance should be reviewed to ensure
finance to be allocated correctly b/w compliance with relevant IFRSs.
share capital and share premium and the
loan to be properly presented as a non-
current liability. Disclosures need to be
sufficient to comply with IFRSs. If the
above is not treated corrected then this
could materially mis-state the Financial
Statements.
The loan has covenant attached to it. Obtain and review covenant calculations to
If these are breached then the loan would identify any breaches. If there is any the
be repayable straight away and would likelihood of the bank demanding repayment
need to be classified as a current liability, will need to be assessed and the potential
potentially resulting in net current impact on the company. The need to avoid
liability position on the statement of breaching the covenants reinforces the audit
financial position. If the company did not team’s need to maintain professional scepticism
have sufficient cash available repay the in areas that could be manipulated.
loan balance the going concern status of
the company could be threatened. If the
above happens then Financial Position
need to be prepared on break-up basis.
The finance director has announced that Review the reasonableness of the valuation and
all land and buildings will be revalued as assess the competence, experience and
at the year end. independence of the individual performing the
The revaluation surplus or deficit is likely valuation.
to be material, there is increased risk over Ensure whether the split of surplus/deficit
split of revaluation gain between Profit or between Profit or Loss and Other
Loss and Other Comprehensive Income. If Comprehensive Income is in accordance with IAS
gain is wrongly classified to Profit or Loss 16 Property, Plant and Equipment also
instead of Other Comprehensive Income, recalculate to ensure that land and buildings are
this will affect many accounting ratios included at a reasonable amount in the
relating to Profit figure in Statement of statement of financial position.
Profit like Net Profit Margin, Interest
Cover, Price earning ratio etc. Hence
misleading user of Financial Statements
Revenue Recognition
The requirement for customers to pay Enquire of management the point at which
40% on ordering and the remainder revenue is actually recognized, and review the
following delivery could result in revenue system of accounting for deposits to ensure they
recorded before it should be, if the are not included in revenue until goods
deposit is recorded as a sale and not delivered and signed for.
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deferred until delivery. This would result For a sample of transactions within 8 weeks of
in revenue being overstated. the year end, ensure the revenue recorded is
Alternatively, revenue could be only in respect of goods delivered to customers
understated if the final payment were in the same period and ensure they have been
only recognized when it is received, signed for.
rather than on delivery.
Expenditure Recognition
Contractors are required to invoice at the Review invoices and payments to contractors
end of each month but often there is after the year end, and if they relate to work
delay in receiving these. There is undertaken before the year end, ensure they are
therefore a risk the company will not included as accruals.
accrue for cost, resulting in incomplete
liabilities and understatement of
expenses.
The new premises purchase was funded Re-perform the calculation of the split between
by a bank loan which may not be current and non-current liabilities and ensure
classified correctly between current and the loan is properly presented and terms are
non-current liabilities, or may not be disclosed as required by IFRSs.
properly presented or disclosed as
required by IFRSs.
If non-current liability is presented as
current, then many ratio (like Debt to
Equity ratio) used to assess the risk level
of company by the stakeholder may show
different picture thus misleading them.
The warehouse disposed of during the The non-current asset register should be
year may have been incorrectly reviewed to ensure that the asset has been
accounted for resulting in a potential removed. Disposal proceeds should be agreed to
overstatement of non-current assets and bank statements and the profit on disposal
the related profit on disposal. should be recalculated.
Due to Sunflower conducting numerous A sample of sites should be visited with those
inventory counts simultaneously on 31 holding material inventory, including the
December it may not be possible to warehouse, prioritised. Supermarkets with a
attend all counts. As a result there is a risk history of inventory count issues should also be
sufficient appropriate audit evidence may visited.
not be gained over inventory in the
financial statements.
Transfer of opening balances to head Enquire of management how the data was
office may not have been performed transferred, what controls were in place and
completely and accurately. If the opening which procedures were performed to confirm
balances are misstated, for some the transfer was complete and accurate. Review
statement of financial position accounts the journal(s) made to transfer the opening
(such as non-current assets) the closing balances and compare with the prior year
balances may also be misstated. financial statements to ensure they were as
expected.

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Power of Expression:
In the exams we need to express power of expression in for words in our writing i.e.
as if the exam paper has been taken by a professional. In order to do that we need to
use certain words, which are as follow;

Related to Risk
➢ Report produced
➢ Inspect, review, verify, determine, resolve, investigate instead of check
➢ To confirm, verify instead of to see
➢ Carried out instead of taken
➢ Due to instead of because of
➢ Risk of misstatement arising from instead of because of
➢ Assess the adequacy of internal control around inventory… instead of Relating
➢ Considered to be inadequate instead of seems
➢ Establish, introduce, deliberately
➢ Inflate the profit figure instead of increase
➢ Increased risk over
➢ Another audit manager should be appointed instead of audit manager should be
replaced.
Related to Systems
➢ Out of the bank instead of from the bank
➢ Trace though the system instead of check through the system
➢ Automatically generated instead of produced
➢ Retained by the warehouse instead of held by the warehouse.
➢ Inspect “XX” for approval by the director instead of confirmation.
➢ Requested by the sales manager instead of asked.
➢ Attempt to place an order instead of try.

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Important definitions
Professional scepticism
Professional scepticism is an attitude that includes having a questioning mind, being
alert to conditions which may indicate possible misstatement due to error or fraud,
and subjecting audit evidence to a critical assessment rather than just taking it at
face value.

It is important that professional scepticism is maintained throughout the audit to

reduce the risks of;
➢ overlooking unusual transactions
➢ over-generalising when drawing conclusions
➢ using inappropriate assumptions in determining the nature, timing and extent of
audit procedures.

Professional scepticism is necessary to the critical assessment of audit evidence. This

includes questioning contradictory audit evidence and the reliability of documents
and responses from management and those charged with governance.

Professional judgement
Professional judgement is the application of relevant training, knowledge and
experience in making informed decisions about the appropriate courses of action in
the circumstances of the audit engagement. The auditor must exercise professional
judgement when planning an audit of financial statements.

Professional judgement will be required in many areas when planning. For example;
➢ the determination of materiality for the financial statements as a whole and
performance materiality levels will require professional judgement.
➢ when deciding on the nature, timing and extent of audit procedures.

Materiality
➢ ISA 320 Materiality in planning and performing an audit state that
“misstatements are considered material if they individually or in aggregate, could
reasonably be expected to influence the economic decisions of users.”
➢ Materiality level means acceptable level of misstatement.
➢ ISA 320 also states that judgements about materiality are affected by the;
o size and/or nature of a misstatement.
o circumstances surrounding the entity.
➢ Different materiality level can be set for different class of transaction and a/c
balance Professional judgement will need to be exercised when determining
materiality for the F.S as a whole.

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➢ Benchmarks and percentages are often used to calculate a materiality level for
the financial statements as a whole, e.g.
o 5% of profit before tax (PBT)
o 1-2% of total assets
o ½-1% of revenue

Performance materiality
The amount or amounts 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.

Components of Audit Risk

➢ Inherent risk
➢ Control risk
➢ Detection risk

Inherent Risk
Inherent risk is the susceptibility of an assertion about a class of transaction, account
balance or disclosure to a misstatement that could be material, either individually or
when aggregated with other misstatements, before consideration of any related
controls.
Factors which may increase inherent risk include:
➢ Changes in the nature of the industry the company operates in
➢ A high degree of regulation over certain areas of the business
➢ Going concern issues and loss of significant customers
➢ Expanding into new territories
➢ Events or transactions that involve significant accounting estimates
➢ Developing new products or services, or moving into new lines of business
➢ The application of new accounting standards
➢ Pending litigation and contingent liabilities

Control risk
Control risk is the risk that a misstatement that could occur in an assertion about a
class of transaction, account balance or disclosure and that could be material, either
individually or when aggregated with other misstatements, will not be prevented, or
detected and corrected on a timely basis by the entity's internal control.

The following factors may increase control risk:

➢ Changes in key personnel such as the departure of key management
➢ A lack of personnel with appropriate accounting skills
➢ Deficiencies in internal control
➢ Changes in the IT environment
➢ Installation of significant new IT systems related to financial reporting

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Detection Risk
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, either individually or when aggregated with other
misstatements.

Detection risk is affected by sampling and non-sampling risk. Factors which may
result in an increase include:
➢ Poor planning
➢ Inappropriate assignment of personnel to the engagement team
➢ Failing to apply professional scepticism
➢ Inadequate supervision and review of the audit work performed
➢ Incorrect sample sizes
➢ Incorrect sampling techniques performed

Importance of assessing risks at planning stage or

Importance of ISA 315
ISA 315 says that the auditor shall identify and assess the risks of material
misstatement at the financial statement level and at the assertion level for classes of
transactions and related disclosures, and account balances and related disclosures.

It is very important that auditors carry out this risk assessment at the planning stage
because:
➢ It helps the auditor gain an understanding of the entity for audit purposes
➢ It helps the auditor focus on the most important areas of the financial statements
(where material misstatements are more likely), therefore increasing efficiency
➢ The risk assessment will form the basis of the audit strategy and the more
detailed audit plan
➢ Once the risks have been assessed, audit team members of sufficient skill and
experience can be allocated to maximise the chance of those risks being
addressed.

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