VARSITY COLLEGE
Welcome to
AUDI7319 LU1 PART THREE
Tasneem Motala
AUDI7311
LET'S LOOK AT THE POSITIVES
DON’T BE THIS GUY…
LESSON PLAN
Assessing risk
The audit risk model
The risk of material misstatement
Responding to the risk of material misstatement
VC Learn Activity 1.2.1
10 minute break
Graded questions - Q19 and Q20
Assessing risk
Having accepted the engagement (phase 1) and having obtained (or updated) his or her
understanding of the entity (phase 2), the auditor is now ready to assess the degree to which
there is risk that the financial statements may be materially misstated (i.e. to perform risk
assessment procedures) and will thus move into phase 3 of the audit planning process.
Due to the nature of audit, we know the following...
Cannot test every transaction/conclude 100% certainty
Judgement involved about nature and extent of testing
Use of sampling
Always element of risk that we will not detect misstatements
Audit risk: express opinion that financial statements are fairly presented, when they are not
Assessing risk (Continued)
In terms of the ISAs, the auditor is required to reduce this audit risk to acceptably low levels.
I.e. to an acceptably low level that opinion expressed isn’t inappropriate.
Professional judgement is applied to determine what acceptably low is
Let's look at the different types of engagements...
Level of audit risk auditor is willing to
Type of engagement Description
accept
-Known reliance placed on audit opinion
High-risk engagements Relatively low
-Large degree of public interest
Normal (or medium) -Engagement that typically cannot
Normal
risk engagements be classifed as high or low risk
No outside reliance placed on audit opinion
Low-risk engagements Relatively Higher
-No degree of public interest
Assessing risk (Continued)
What are the implications if auditor ends up with:
-Higher audit risk than is acceptable?
-Lower audit risk than is acceptable?
Factors that increase/reduce audit risk categorised into three components:
Inherent risk
Control risk
Detection risk
Assessing risk (Continued)
Let's have a look at the 3 components in more detail...
Inherent risk Control risk Detection risk
Susceptibility of an assertion to Risk that material misstatement Risk that auditor’s procedures fail
material misstatement not prevented, detected and corrected to detect material misstatement
before considering internal control by system of internal control
Inappropriate/inadequate audit
Intrinsic to entity, its nature, business. Specific to entity as a result
procedures = higher detection risk
of nature of controls
Cannot be changed by auditor
Cannot be changed by auditor Can be changed by auditor
Aggressive Financial Targets
Audit staff
Staff competence Higher control risk = higher
risk of material misstatement Type of audit testing
Complexity of transactions and vice versa New Audit Client
Tight Audit Deadline
information systems Segregation of duties
Control environment Extent of audit testing
History of misstatements
Control activities
Management incentives
Monitoring of controls
Textbook pg 496 Textbook pg 498 Textbook pg 498
The audit risk model
The Audit Risk Model
AR = IR X CR X DR
What if the auditor is faced with
increased Inherent risk or increased control risk?
The auditor will need to reduce the detection risk to offset the
increase in inherent/control risk and return audit risk to an
acceptable level
How will the auditor do this?
Effective design of substantive procedures
We must assess IR and CR to determine required level of DR
AR (Fixed) = IR X CR X DR
The risk of material misstatement
ISA 315, Auditor to consider risk of material misstatement at:
Financial statement level Assertion level
Risks across entire set of financial statements. Risks in specific account balances,
classes of transactions, disclosures.
These are risks that are pervasive to the financial statements
as a whole and potentially affect many assertions. The following needs to be considered with
assessing risks at the assertion level:
• The susceptibility of accounts to misstatement
• The complexity of the underlying transactions
• The degree of judgment involved in
determining account balances
• The susceptibility of assets to loss or misappropriation
• The conclusion of unusual and complex transactions
• Transactions not subjected to routine processing
Textbook pg 501 - 503
The risk of material misstatement (Continued)
Consideration of going concern, fraud risk and risks that require special audit
considerations (Significant risk)
Significant
Going concern
risk
Inherent risk
Usually due to non-routine,
Increased RMM at financial statement Fraud unexpected circumstances
level
Develop specific response
Possibility of manipulation of ISA 240 - reasonable assurance to the risk
amounts, disclosures to present whether free from material
better picture misstatements, Significant risks are usually
whether due to error or fraud inherent risks
Formal going concern
assessment
When identify and assess RMM:
consider whether due to fraud
Audit procedures
Responding to the risk of material misstatement
Responding to detection risk at the financial statement level:
Determine level of DR to bring audit risk AR down to acceptably low level with
reference to IR and CR
Because RMM at financial statement (FS) level: response should address whole FS.
Options available to the auditor to meet changes to level of detection risk:
Nature, timing of audit procedures
Professional skepticism Engagement supervision
Engagement team
Extent of audit procedures
Accounting policies
Review process
Audit partner involvement Unpredictability
Responding to the risk of material misstatement
Responding to detection risk at the assertion level:
To change level of DR, alter three areas for substantive procedures:
Nature,
Timing and/or
Extent of planned audit procedures.
There are two audit approaches to respond to RMM:
Combined approach (“controls-based” approach) Substantive approach
-Tests of controls with limited substantive procedures
-Where we do not or cannot rely on internal controls
-Auditor chooses to place reliance on internal controls
-CR thus automatically high, therefore reduce DR
If so, must test operating effectiveness.
Thus more extensive substantive procedures.
-Testing corroborates or reduces assessment of CR
-All audit evidence through substantive procedures.
-If reduces, then higher DR in substantive tests justified
ARC Activity 1.2.1
