is the risk that an auditor expresses an inappropriate audit opinion
when a financial report is materially misstated.
- –This means the auditor gives an opinion that the financial report is true and fair when it contains a significant error or fraud.
- Audit risk can never be zero. (Ideally low)
- Audit risk is reduced during risk response phase by identifying the key risks and adjusting audit effort accordingly.
- Auditor will plan and perform their audit to reduce audit risk to an acceptably low level
The risk that an auditor will issue an unqualified opinion on materially misstated financial statements at
- Financial statement level
- Individual account balance or class of transactions level
3 components of audit risk
- Inherent risk (IR): Risk that a material misstatement could occur due to the nature of the entity/industry/economy level factors.
- Control risk (CR): Risk that client’s system of internal controls will not prevent or detect such a material misstatement.
- Detection risk (DR): Risk that the auditor’s testing procedures will not be effective in detecting a material misstatement, should there be one.
There is an inverse relationship between IR and CR and DR.
Stages in audit risk minimisation: assess inherent risk
Identification of accounts and related assertions most at risk of material misstatement.
Assertions are statements made by management about recognition, measurement, presentation and disclosure of items in financial report and notes.
Statements of ‘truth’ about financial statements.
»For example, all inventory items stated on balance sheet actually exist (existence).
Where does risk come from?
–related to significant economic or accounting developments
–significant related party transactions (arms length)
–significant subjectivity in measurement of financial information
–significant transactions outside the client’s normal course of business.
Assess control risk
- Assessment of client's system of internal controls.
- Auditor plans to undertake detailed testing of each identified account: based on auditor's assessments of riskiness of account and related assertions and effectiveness of the client's system of internal controls.
Audit risk= IR x CR x DR
- Inherent and control risk: risk that material misstatement exist. No auditor effect (maybe after a long time from recommendations)
- Detection risk: risk that auditor will not detect misstatements.
- Auditor can affect DR level by audit evidence gathering efforts.
The magnitude of an omission or misstatement of accounting information that makes it probable that the judgment of a reasonable person relying on the information would be changed or influenced by the omission or misstatement.
Materiality guides audit planning, testing, and assessment of information in financial report.
Information is material if it impacts on the decision-making process of users of the financial report.
Qualitative materiality nature of the item
- Non-compliance with laws
- Related party transactions
- Change of accounting methods
Quantitative materiality magnitude of item
Set as a % of relevant base
2. Setting materiality
–Auditor uses professional judgement
- –Audit firms vary in methods to set materiality percentages in the risk assessment phase to derive at an appropriate base percentage.
- Balance sheet bases include total assets or equity.
- Income statement bases include profit before tax, revenue or gross profit.
–Setting lower materiality level during planning increases quality and quantity of evidence required to be gathered.
- How the auditor will conduct the audit
- A customised plan
- Sets scope, timing, and direction of the audit
- Provides basis for developing detailed audit plan
- Is based on preliminary assessments of IR and CR
Audit strategy 1: substantive approach
- Inherent risk: high
- Control risk: high
- Detection risk: low
- Increased reliance on substantive tests of transactions and account balances.
Audit strategy 2: controls approach
- Inherent risk: low
- Control risk: low
- Detection risk: higher
- Reduced reliance on substantive tests of transactions and account balances.
- Test controls more.
- Will never use this on its own.
Client approaches to measuring performance
As part of gaining understanding of client, auditor should learn how client measures its own performance.
–Client uses key performance indicators (KPIs) to monitor and assess its performance and staff performance, and KPIs can be written into contracts between client and others.
–Auditor needs to understand what client focuses on, and what is potentially at risk of misstatement.
Client approaches to measuring performance: Profitability
Profit by division, branch, manager etc.
–Price earnings ratio (P/E).
–Earnings per share (EPS): Decline could signal pressure on management.
–Cash Earning per share (CEPS).
–Inventory turnover: Decline could signal overvalued stock.
Client approaches to measuring performance: Liquidity
–Ability of company to meet its cash needs in short and long term.
–Ratios can be written into debt contracts (as covenants) and restrict client’s actions.
–Client potentially under pressure to misstate accounts included in ratios.
Evaluation of financial information by studying plausible links among both financial and non-financial data.
–Identify fluctuations in accounts that are inconsistent with auditor’s expectations based on their understanding of the client.
Analytical procedures can be conducted throughout audit
Analytical procedures are conducted at the risk assessment phase of the audit to:
–highlight unusual fluctuations in accounts
–aid in risk identification
–enhance the understanding of the client
–identify accounts at risk of material misstatement
–risk assessment phase analytical procedures.
Analytical procedures: comparisons
$ amount or % change
-Account balances for the current year and the previous year.
-Account balance for the current year and the budget.
-Auditor will assess these changes in light of their expectations based upon their understanding of the client.
Analytical procedures: Trend analysis
-Comparison of account balances over time.
-Select base year, restate all accounts in subsequent years as a % of that base.
-Auditor should factor in client and economic changes, and form expectations of reasonable changes in balances over time.
Analytical procedures: 3.Common-size analysis (vertical analysis):
-Comparison of account balances to single line item.
-Balance sheet – express each item as % of total assets.
-Income statement – express each item as % of sales.
-Using analysis over several years, auditor can see how each account contributes to totals, and how this changes over time.
Analytical procedures: ratio analysis
-Assess relationship between various financial report balances, and between them and non-financial items.
- -An auditor will calculate:
- profitability ratios
- liquidity ratios
- solvency ratios.
- –Interpreting results of ratio analysis:
- Compare results to previous years’, budgets, competitors.
- Discuss significant variation with management.
- Consider effects on future viability of company (going concern risk).
- Lack of variation in results could be unexpected if conditions have changed.
- Where results are unusual or unexpected, investigate further because it indicates risk of material misstatement.
6.Factors to consider when conducting analytical procedures:
Is the data reliable?
–Has client data been audited? Is external data reliable?
–Poor controls would signal higher risk in relying on analytical procedures.
–Change in accounting methods could distort data.
–Auditor may have access to half-year results only.
–Reliability of budget setting process – is client continually missing budgeted targets?
–Are industry comparisons valid?