Lesson 5: Audit risk And audit evidence

Question 1

What type of approach is required by ISAs when auditing?

Answer 1

Risk-based approach

Question 2

What happens in a risk-based approach?

Answer 2

Auditors analyse the risks associated with the client’s business, transactions and systems which could lead to misstatements in the financial statements, and direct their testing to risky areas

Question 3

Define audit risk

Answer 3

Audit risk is the risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated

Question 4

What two levels can a misstatement be at?

Answer 4

Financial statement level

Individual account balance or disclosure leve

Question 5

Audit risk has two major components,

what are they?

Answer 5

One is dependent on the entity, and is the risk of material misstatement arising in the financial statements (inherent risk and control risk).
The other is dependent on the auditor, and is the risk that the auditor will not detect material misstatements in the financial statements (detection risk

Question 6

What is the equation for audit risk?

Answer 6

Audit risk = Inherent risk x Control risk x Detection risk (AR = IR x CR x DR)

Question 7

Define inherent risk

Answer 7

Inherent risk is the probability of loss based on the nature of an organization’s business, without any changes to the existing environment. The concept can be applied to the financial statements of an organization, where inherent risk is considered to be the risk of misstatement due to existing transactional errors or fraud.

Question 8

Define controlled risk

Answer 8

Control risk is the probability that financial statements are materially misstated, due to failures in the system of controls used by a business.

Question 9

Define detection risk

Answer 9

This risk is caused by the failure of the auditor to discover a material misstatement in the financial statements.

Question 10

Finish the sentence Detection risk is a function of the effectiveness

Answer 10

of an audit procedure and of its application by the auditor.

Question 11

What is Professional scepticism

Answer 11

‘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.’

Question 12

What are the three risk assessment procedures

Answer 12

Inquiries of management and other within the entity
Analytical procedures
Observation (e.g. of control procedures) and inspection (e.g. of key strategic documents and procedural manuals).

Question 13

Inquiry

Answer 13

The auditors will usually obtain most of the information they require from staff in the accounts department, but may also need to make enquiries of other personnel, for example, internal audit, production staff , management or those charged with governance.

Question 14

Observation and inspection

Answer 14

Include observing the normal operations of a company, reading documents or manuals relating to the client’s operations or visiting premises and meeting staff.

These techniques are likely to confirm the answers made to inquiries made of management.

Question 15

What does Analytical procedures mean

Answer 15

‘Analytical procedures’ means the analysis of relationships to identify inconsistencies and unexpected relationships.

Question 16

Analytical procedures include the following type of comparisons:
name the 6

Answer 16

(a) Prior periods
(b) Budgets and forecasts
(c) Industry information
(d) Predictive estimates
(e) Relationships between elements of financial information, ie ratio analysis
(f) Relationships between financial and non-financial information, e.g. payroll costs to the number of employees

Question 17

What are the 7 types of audit evidence that every audit procedure obtains one or more

Answer 17

1. Inspection
2. Observation
3. Confirmation
4. Recalculation
5. Reperformance
6. Analytical procedures
7. Inquiries of the client

Question 18

What happens during inspection and observation

Answer 18

Inspection—The auditor’s examination of the client’s documents and records to substantiate the information in the financial statements.
Observation—Watching a process or procedure being performed by others.

Question 19

What happens during confirmation and recalculation

Answer 19

Confirmation—The receipt of a direct written response from a third party verifying the accuracy of information that was requested by the auditor.

Recalculation—Rechecking a sample of calculations made by the client.

Question 20

What happens during reperformance and analytical procedures

Answer 20

Reperformance—The auditor’s test of client accounting procedures or controls.Analytical
Procedures—The evaluation of financial information through analysis of plausible relationships among financial and nonfinancial data and are required during planning and completion phases of all audits.

Question 21

What happens during the last stage if inquiry

Answer 21

Inquiry—Obtaining written or oral information from the client in response to auditor questions. Usually not considered conclusive unless it is corroborated.

Question 22

Responding to the risk assessment

Answer 22

The auditor shall formulate an approach to the assessed risks of material misstatement.

ISA 330 The objective of the auditor is to obtain sufficient appropriate audit evidence regarding the assessed risks of material misstatement, through designing and implementing appropriate responses to those risks.

Question 23

To respond appropriately to financial statement level risks, the auditor may do the following:

Answer 23

Assign more experienced personnel or those with specialized knowledge.
Evaluate the selection and application of accounting policies to identify earnings management or bias that may create a material misstatement.
Incorporate additional elements of unpredictability in the selection of audit procedures.

Question 24

What does the ISA 330 say aboutResponses to the risks of material misstatement at the assertion level

Answer 24

ISA 330 says that the auditor shall design and perform further audit procedures whose nature, timing and extent are based on and are responsive to the assessed risks of material misstatement at the assertion level

Question 25

What does Nature

Answer 25

'Nature' refers to the purpose and the type of test that is carried out, which include tests of controls and substantive tests.

Question 26

Define substantive procedures

Answer 26

Substantive procedures are audit procedures designed to detect material misstatements at the assertion level. They consist of tests of details of classes of transactions, account balances and disclosures, and substantive analytical procedures.

Question 27

Substantive Procedures Related to the Financial Statement Closing Process

Answer 27

In addition, the auditor shall carry out the following substantive procedures: Agreeing or reconciling the financial statements to the underlying accounting records Examining material journal entries Examining other adjustments made in preparing the financial statements

Question 28

Analytical procedures and Tests of details

Answer 28

Substantive procedures fall into two categories: analytical procedures and tests of details. The auditor must determine when it is appropriate to use which type of substantive procedure. Analytical procedures as substantive procedures tend to be appropriate for large volumes of predictable transactions (for example, wages and salaries). Tests of detail may be appropriate to gain information about account balances for example, inventory or trade receivables. In tests of details the auditor is concerned with overstatement or understatement of the line item in the financial statement.

Question 29

Timing of Substantive Procedures

Answer 29

Primarily as a practical matter, substantive procedures may be performed at an interim date Only using interim testing procedures will increase the risk that misstatements existing at the period end will not be detected. Performing audit procedures at an interim date may assist the auditor in identifying and resolving issues at an early stage of the audit.

Question 30

DocumentationThe auditor shall include in the audit documentation:

Answer 30

(a) The overall responses to address the assessed risks of material misstatement at the financial statement level, and the nature, timing, and extent of the further audit procedures performed; (b) The linkage of those procedures with the assessed risks at the assertion level; and (c) The results of the audit procedures, including the conclusions where these are not otherwise clear.