AUDIT PLANNING

& FIELDWORK: PART 2-

PRELIMINARY ANALYTICAL
PROCEDURES,MATERIALITY,
AUDIT RISK & SAMPLING
Test 2
 Preliminary analytical procedures
PURPOSE :
 To assist in planning the nature, timing & extend of Audit
procedures
 To identify potential errors
 To determine areas that require detailed checking &
substantive tests

ANALYSE SIGNIFICANT RATIOS & TRENDS

 Investigate the relationship in order to determine whether
data / account balances appear to be reasonable
 Computation of key ratios:
 Gross Profit
 Current Ratio
 Materiality - definition

ISA 320

“Information is material if its omission or misstatement

could influence the economic decisions of users taken on the
basis of the financial statements. Materiality depends on the
size of the item or error judged in the particular
circumstances of its omission or misstatement. Thus,
materiality provides a threshold or cut-off point rather than
being a primary qualitative characteristic which
information must have if it is to be useful.”
 
 MATERIALITY….cont’d
Is a criterion for determining the items require
attention & detail examination
Needs to consider both the quantitative & qualitative
(nature) of the misstatement
Common bases in judging materiality (quantitative))
 Total Assets, Total Revenue, NPBT, GP

Qualitative aspects that affect materiality:

 Use of inappropriate / inadequate accounting policy
 Cumulative small amount of misstatements  material mstmt
 Fraud/non-compliance with laws & regulations
 Amounts that affect trend in earnings
 AUDIT RISK
DEFINITION:
Audit risk is the risk that the auditor gives an
unmodified/unqualified audit opinion when the financial
report is materially misstated

AUDIT RISK MODEL:

Audit risk (AR) = Inherent risk (IR) × Control risk
(CR) × Planned Detection risk (PDR)
 
 2 TYPES OF RISK FACED BY AN
AUDITOR
1. AUDIT RISK
 Risk that auditor gives inappropriate audit opinion on FS that
are materially misstated
 Can be directly controlled
 3 components of audit risk:
 Inherent risk
 Control risk
 Detection risk
2. AUDITOR’S BUSINESS RISK
 Auditor’s exposure to loss/injury from litigation, adverse
publicity/ other events arising in connection with FS audited
and reported on
 Cannot be directly controlled
 Business Risks

Example:
litigation
sanctions imposed by public or regulatory bodies
(eg Bursa Malaysia and the professional
accounting bodies)
impaired professional reputation, which can
occur as a result of litigation or adverse publicity
 Definition of audit risks component – ISA 200

 ‘Inherent risk’ is the susceptibility of an assertion to a misstatement that could be material, either
individually or when aggregated with other misstatements, assuming that there are no related
controls. The risk of such misstatement is greater for some assertions and related classes of
transactions, account balances, and disclosures than for others”. (paragraph 29)
 
 “‘Control risk” is the risk that a misstatement that could occur in an assertion 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. That risk is a function of
the effectiveness of the design and operation of internal control in achieving the entity’s objectives
relevant to preparation of the entity’s financial statements. Some control risk will always exist
because of the inherent limitations of internal control”. (paragraph 29)
 
 ‘Detection risk’ is the risk that the auditor will not detect a misstatement that exists in an assertion
that could be material, either individually or when aggregated with other misstatements. Detection
risk is a function of the effectiveness of an audit procedure and of its application by the auditor.
Detection risk cannot be reduced to zero because the auditor usually does not examine all of a class
of transactions, account balance, or disclosure and because of other factors. Such other factors
include the possibility that an auditor might select an inappropriate audit procedure, misapply an
appropriate audit procedure, or misinterpret the audit results. These other factors ordinarily can be
addressed through adequate planning, proper assignment of personnel to the engagement team, the
application of professional skepticism, and supervision and review of the audit work performed”.
(paragraph 31)[2]
 AUDIT RISK MODEL
AR = IR x CR x DR

 Inherent Risk (IR)

 The susceptibility of an assertion to material misstatement in the FS
in the absence of internal control (IC)
 Also called Auditee Risk where it is influenced by the business
characteristics of the client & the industry it operates.
 The risk of such misstatement is greater for some transactions &
accounts than for others. Eg: amount derived from a complex
calculations/accounting estimates pose greater risks of material
misstatement than accounts derived from routine, factual data.
 AUDIT RISK MODEL
 AR = IR x CR x DR

 Control Risk (CR)

 Risk that material misstatements will not be prevented/detected on
a timely basis by an entity’s IC

 Detection Risk (DR)

 Risk that Substantive audit procedures performed will not detect a
material misstatement that exists in an ac balances/ class of
transaction
 Also it relates to the nature, timing & extent of the auditor’s
procedure. This risk can be controlled through the design & scope of
Audit Procedure.
 Relationship between Materiality and Audit
Risks
 concepts of risks and materiality go hand-in-hand in the sense that the
auditor collects evidence to determine the risk that a material
misstatement exists in the financial statements.
 There is an inverse relationship between materiality and the level of
audit risk and in determining the nature, timing and extent of audit
procedures, auditors should take into account this inverse relationship.
Eg. If materiality level is lower, audit risk is increased
 How is the AR model used?
 1. Set the AR 2. Assess the IR
 3. Assess the CR 4. Determine the DR
 The auditor’s assessment of materiality and audit risk when evaluating
the results of audit procedures may be different at the time of initially
planning the engagement because of a change in circumstances or
because of a change in the auditor’s knowledge as a result of the audit.
 HOW TO ASSESS AUDIT RISK?
The Auditors assessment of AR & its components
(IR/CR/DR) represent a matter of professional
judgement by the auditor
Inherent Risk (IR)
 Knowledge of client’s buz during 1st vs recurring audit
 Mgmt integrity
 Client motivation to make mistake
 Client knowledge of acc.std
Control Risk – segregation of duties & inherent
limitation of IC
Detection Risk – Decide on nature, timing & extent
Examples of circumstances Indicating
Increased Risk of Errors & Fraud
 Analytical procedures disclose major differences from
expectations
 Unreconciled differences exist between a control a/c & sub.
Records
 Confirmation requests disclose significant differences or a
lower than expected response rate.
 Transactions lack proper documentation or authorisation
 Errors known to client personnel are not voluntarily
disclosed to the auditor
 STEPS TO MINIMISE AR
Plan & delegate the audit with due care
Audit evidence are properly documented
Audit staff selected are competent to perform the
audit with due care
Sample selected should rep. the population
Avoid misunderstanding with client
Use audit manual
Communication channel between audit staff must be
good in order to solve problem on timely basis
The audit fee should be based on the work done
Assessing Risks of Material Misstatement- ISA 315
 
“The auditor should identify and assess the risks of material
misstatement at the financial statement level, and at the assertion level
for classes of transactions, account balances, and disclosures. For this
purpose, the auditor:
 
identifies risks throughout the process of obtaining an understanding of the entity
and its environment, including relevant controls that relate to the risks, and by
considering the classes of transactions, account balances, and disclosures in the
financial statements

relates the identified risks to what can go wrong at the assertion level

considers whether the risks are of a magnitude that could result in a material
misstatement of the financial statements
 
considers the likelihood that the risks could result in a material misstatement of
the financial statements
Risk consideration in Evaluating Audit
Results
An assessment of audit risk, that recognises the
components of audit risks, should be undertaken at the
audit planning stage and later integrated into the audit of
individual account balances or transaction classes. It is an
important aspect of the analytical procedures, which
underpin all cost-effective audits, and should also occur at
the final audit of the financial report, and in the assessment
of the firm as a going concern .Thus, risk analysis
techniques should be applied at the micro level in the audit
of account balances and at the macro level in an overall
appraisal of the firm and its financial report.
Risk of Material Error
 Risk Analysis of a Business as a Going
Concern

Considerations when evaluating appropriateness of Gong

concern assumption

 Third Party Support – whether it is available

 Indications of Going Concern and Mitigating Factors

 Indications of “Going Concern” Problems
 Examples of Mitigating Factors
 AUDIT SAMPLING

o Since the auditor cannot examine every item, the auditor has to select a
sample of items for testing; i.e “audit sampling”
o Audit sampling is the application of audit procedures to less than 100% of
the items within an account balance or class of transactions, to enable
auditors to obtain and evaluate audit evidence about some characteristic of
the items selected in order to form or assist in forming a conclusion
concerning the population.

1.1 “Precision” and “Reliability”

 Precision and Reliability

Statistical samples are evaluated in terms of

“precision”, which is expressed as a range of values,
plus or minus, around the sample result, and
“reliability” (or confidence), which is expressed as a
proportion of such ranges from all similar samples of
the same size that would include the actual population
value.
  
ADVANTAGES OF STATISTICAL SAMPLING

 permits the auditor to calculate precision and reliability or

confidence level
 requires the auditor to plan the audit approach in a systematic
and scientific manner
 permits the auditor to interpret the sampling results objectively
on the basis of values for precision and reliability (confidence
level)
 permits the auditor to rely on a smaller sample than would be
the case for judgement sampling
 permits a more intensive examination of sample items since with
smaller sample sizes the auditor is able to thoroughly scrutinize
each item that is drawn
 AUDIT PROCESS & STATISTICAL
SAMPLING
Important factors:
Methods of Sample Selection
 Sample Size
Table 8.1
Factors Influencing Compliance Test (Test of Controls) Sample Size

  Conditions Leading to:

Factor Smaller Sample Size Larger Sample Size
(a) Planned reliance on (1) Higher reliance on internal Lower reliance on internal
internal control control control
 

(b) Allowable rate of Higher acceptable rate of Lower acceptable rate of

deviation (tolerable deviation for planned deviation for planned
reliance on internal control reliance on internal control
error)
(c) Allowable risk of Higher risk of over-reliance Lower risk of over-reliance on
over-reliance on internal control internal control
 

(d) Likely rate of (2) Lower expected rate of Higher expected rate of
population deviation deviation in population deviation in population

(e)Number of items in Virtually no effect on sample size unless population is small

population
 Sample size ..cont’
Table 8.2
Factors Influencing Substantive Test Sample Size
  Conditions Leading to:
Factor Smaller Sample Size Larger Sample Size
(a)Reliance on internal Higher reliance on internal Lower reliance on internal control
control control  
(b)Reliance on other Higher reliance to be placed on Lower or no reliance to be placed
substantive tests related to other substantive tests on other substantive tests
same audit objective and  
class of transactions
(c)Measure of tolerable error Larger measure of tolerable error Smaller measure of tolerable error
for a specific audit objective  
(d)Expected size and Smaller errors or lower frequency Larger errors or higher frequency
frequency of errors  
(e)Population value Smaller monetary significance to Larger monetary significance to
the financial information the financial information
 
(f)Number of items in Virtually no effect on sample size unless population is small
population
(g)Overall assurance Lower overall assurance Higher overall assurance
required
(h)Stratification Stratification of the population, if No stratification of the population
appropriate  
Compliance Testing-Steps
Substantive Testing
 SUMMARY
 Preliminary analytical procedures
 Audit Risks & components of audit risk
 Relationship between materiality and audit risks
 Assessing Risks of Material Misstatement
 Business Risks
 Risk Analysis of a Business as a Going Concern
 Audit Sampling
 “Precision” and “Reliability”
 Advantages of Statistical Sampling
 Audit Process and Statistical Sampling
 Methods of Sample Selection