Question 1(a) Audit risk may be defined as the risk that the auditor will deliver an inappropriate or incorrect audit

opinion on the financial statements. The auditor's assessment of risk should be an intrinsic part of the planning and execution of an audit. The auditor should plan the distribution of audit effort by identifying the areas involving greatest audit risk, in terms of their materiality, the existence of adequate internal controls, and previous experience. Detailed testing can then be concentrated on high risk areas. Audit risk is reduced by appropriate quality control procedures. These include:
i.

The observation of relevant Auditing Standards and Guidelines. The establishment, maintenance and observance of standards of quality within the audit firm. Procedures for ensuring that staff and partners have the ability and knowledge required to do the job. This implies suitable procedures for recruitment, supervision and training. Audit files properly reviewed with points of difficulty or error being cleared before the audit report is signed. Peer review procedures. In addition to routine review of files during the audit, partners should take part in peer review to ensure that the firm's standards are maintained. Procedures on deciding whether to accept an engagement. Before accepting an engagement, the auditor should consider its implications for the firm. Will it threaten the firm's independence? Does the firm have resources to carry out an adequate audit? Does the client present a potential risk because of the nature of its business or its financial position?

ii. iii. iv. v. vi.

Audit risk is made up of three elements: Inherent risk describes the risk arising from the nature of the client's business or industry and environment prior to the consideration of the internal control system by the auditor. It will vary between different account items and different types of industry. Inherent risk is enumerated as below;

(a) The nature of the business, its products or services, and its market position (b) The company's present and likely future financial position (c) The auditor's previous experience of that company
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It entails. (a) The quality and effectiveness of management and the degree of supervision exercised by management. (g) The possibility that error could have a material effect on the Control risk is the risk that errors will not be prevented or detected by audit procedures. (b) The existence and quality of internal controls (c ) The competence of accounting staff (d) The nature of accounting records kept. Detection risk is the risk that material error will not be detected by audit procedures. (a) Being the newly appointed auditors means that our knowledge of the entity its activities and the business risks to which it is exposed is highly inadequate. Our knowledge of the suitability of design and effectiveness of operation of the 2 . Therefore during our inherent assessment we could easily misjudge the competence and integrity of management and staff and their reaction to pressures thereby reducing the population to be subjected to details testing to too small a size. Similarly our knowledge of the competence and integrity of the management and staff and the pressures to which they are exposed at personal and entity levels is also insufficient.(d) The existence of circumstances which could put pressure on management to manipulate results (e) The susceptibility of the company's assets to fraud. (f) The existence of related party or unusual transactions. (e) The existence and effectiveness of the internal audit department. Audit risks facing Super face Ltd The various audit risks apparent from the initial planning discussions in respect of the audit of the annual financial statement for Super Face ltd group for the year ended 30 th September 20X5 includes the following.

In auditing the financial statement of the holding company and the consolidated financial statement. Capital markets authority or the International financial reporting standards (IFRS). The auditor of the holding company may not be the auditor of other subsidiary. the sole responsibility of the sales manager to sell the second hand equipment traded in brings about a risk. authorize. In accordance with the provision of IFRS 3 business combinations group accounts are presented as consolidated financial statement applying the acquisition method of accounting. The company’s in the group are the legal entities in their own right. there is therefore the concern that the auditor of the subsidiary has obtained sufficient and appropriate audit evidence and expressed an appropriate opinion. property plant and equipment valuation will require closer audit scrutiny. We could therefore misjudge the system and reduce the sample size even further to a much smaller size that it should have been. Nairobi Stock Exchange. 3 . The auditor of the subsidiary could have carried out a substandard audit and issued an inappropriate audit opinion and if the subsidiary is material to the operations of the entity the auditor of the holding company could carry over the qualification into the group audit report. However it need not produce group accounts if it is itself a fully owned subsidiary of another company. This function should be performed by different departments and if they cannot be performed by different departments different individuals within this department should perform them and if that is not practicable there should be internal checks i. He is solely responsible for his opinion on the group accounts.accounting and internal control system is equally insufficient. (c) Lack of segregation of duties i. (b) The financial statements could be materially misstated by not complying with the presentation and disclosure requirements of the Company’s Act. The key control procedure for the prevention. The responsibility for selling second hand equipment is given to one manager means that there is no segregation of duties if this manager makes a mistake it will not be detected if he perpetrates an irregularity it will not be detected. (d) The Company’s Act requires that if a public company has a subsidiary at its year end then it should produce group accounts for the benefit of the shareholders of the holding company. the work of an individual should be complementary to the work of another individual or should be subject to supervision and review by another individual. detection and correction in a timely basis of errors and irregularities is segregation of duties for there to be adequate segregation of duties no one individual should be in a position to initiate.e.e. The auditor is concerned that the computations could be incorrect conceptually and arithmetically. execute a transaction have custody of the related assets. They appoint their own auditors. the auditor of the holding company may have to rely on the work of the other auditor to form his opinion on the group accounts. (e) The financial statements could be materially misstated due to manipulation of the figures in the financial statements as the directors are under pressure from competitors thus areas of significant subjective judgment such as stock valuation debtors valuation.

(g)Inventories could be materially misstated due to giving them an inappropriate value particularly any inventories purchased from the foreign supply whose contract with is the subject of legal action. It identifies four possible likelihood of crystallization or materialization. Probable that is very likely to crystallize or materialize and it’s not being practicable to determine with sufficient reliability the financial effect. (i) The contingent liabilities could be materially misstated in that as long as the rental agreement is still in force the customers could default and the financial institution could seek resource from Super face Ltd. Possible that it can materialize or crystallize.(f) Contingent liabilities could be materially misstated as the management many not have identified all the contingent liabilities existing at the balance sheet date or it may not have properly assed the likelihood of crystallization of the identified contingent liabilities and give them the correct accounting presentation and disclosure treatment in accordance with the provisions of the Company’s Act and IAS37 provisions contingent liabilities and contingent assets. (j) If a competitor has used the company there will be contingent liabilities. (h) The cost of sales could be materially misstated because if the discount proceeds are recorded as sales then to comply with the matching concept the cost of the related machine has to be charged to Cost of sales. Probable and it being possible to determine with sufficient of crystallization IAS 37 requires a different accounting treatment this means that this area of contingencies is highly subjective and therefore management and the auditors can disagree or arrive at the wrong assessment with regard to contingent liability the auditor is concerned that management identify all contingent liabilities and the assess them properly with regard to 4 . The authoritative documents on the accounting treatment presentation and disclosure of contingencies are the company’s Act and IAS 37 (provisions contingent liabilities and contingent assets. The net realizable value of the stock items could be significantly lower than the selling price if the Company has been stopped from dealing in the product by a court order due to litigation or by customer caution.) According to IAS 37 the accounting treatment to be given to a contingent liability or asset depends on the likelihood of that contingency crystallization or materializing into a genuine obligation of the entity or an inflow of economic benefits. if one competitor has sued there is a possibility that other competitors could also sue this could mean more contingent liabilities. 1. Remote that is highly unlikely to crystallize or materialize 2. 3. This is due to the discounting arrangement arranged with the financial institution. 4.

The contingent liabilities could be materially misstated if claims for breach of contract by suppliers and customers and claims by employees for unfair dismissal due to the closure of the facsimile assembly division have not been identified assessed for likelihood of crystallization and then properly dealt with in the financial statement. (v) If the system's record was provided by the client or was obtained through reading manuals. Question 1(b) Some of the audit procedures appropriate to address the audit risks identified above are explained as follows. (iv) If the auditor intends to rely on the internal control then he further has to record the system of controls in detail. then the auditor must perform walk through tests to confirm the correctness of the record and also his own understanding of the system (vi) The auditor then performs a preliminary assessment of the system. if he does not wish to rely on the controls then he performs substantive tests on the records (viii) He has to evaluate his evidence and form an opinion on whether proper books of accounts have been kept and whether the books of accounts form a reliable basis for the preparation of the financial statements. Specific control procedures include 5 .their likelihood of crystallization and then deal with the contingent liability properly in accordance with the requirements of the Company’s Act and IAS 37. (ii) By use of enquiry or internal control questionnaires or reading manuals ascertain the complete system. (iii) Record the system that he has ascertained either in the form of narrative notes. flow charts. However. checks lists or answers to the ICQ. (a) Audit procedure with regards to accounting and internal control systems The auditor’s procedures will include: (i) Getting an understanding of the entity as a whole in order to see the accounting system in proper perspective and thus be able to assess how effective and appropriate the system is. and if he is relying on controls then he performs a preliminary evaluation of those controls (vii) If the system of controls and accounting seems adequate and the auditor feels that he can rely upon the controls he then designs and performs compliance tests.

Comparing the results of cash. • Checking the arithmetical accuracy of the records. The auditor should make inquiries of management: (a) To obtain an understanding of: (i) Management‘s assessment of the risk that the financial statements may be materially misstated as a result of fraud 6 . • • Controlling applications and environment of computer information systems. in all material respects. by establishing controls over changes to computer programs Access to data files. Limiting direct physical access to assets and records. • Maintaining and reviewing control accounts and trial balances • Approving and controlling of documents. the auditor should discuss with other members of the audit team the susceptibility of the entity to material misstatements in the financial statements resulting from fraud or error. the use of testing. For these reasons. An audit conducted in accordance with ISAs is designed to provide reasonable assurance that the financial statements taken as a whole are free from material misstatement. • Comparing and analyzing the financial results with budgeted amounts. whether caused by fraud or error. ―Objective and General Principles Governing an Audit of Financial Statements. In planning the audit. (b) Audit procedures on fraud Responsibilities of the Auditor The Auditor has no responsibility for the prevention and detection of fraud and error although the annual audit may act as a deterrent. the inherent limitations of internal control and the fact that much of the evidence available to the auditor is persuasive rather than conclusive in nature. in accordance with an identified financial reporting framework. the auditor is able to obtain only reasonable assurance that material misstatements in the financial statements will be detected. reviewing and approving reconciliations. the objective of an audit of financial statements is to enable the auditor to express an opinion whether the financial statements are prepared. The fact that an audit is carried out may act as a deterrent. for example. • • • Comparing internal data with external sources of information. As described in ISA 200. An audit does not guarantee all material misstatements will be detected because of such factors as the use of judgment.• Reporting. security and inventory counts with accounting records. but the auditor is not and cannot be held responsible for the prevention of fraud and error.

the financial statements are materially misstated as a result of fraud or error. This is a ground for qualification of an auditor's report. they may be sufficient to affect the true and fair view given by the accounts. in some circumstances. Existence of errors may indicate that accounting records are unreliable and are therefore not a satisfactory basis from which to prepare financial statements. or is unable to conclude whether. Documentation The auditor should document fraud risk factors identified as being present during the auditor‘s assessment process and document the auditor‘s response to any such factors. When the auditor identifies a misstatement. to regulatory and enforcement authorities. Communication When the auditor identifies a misstatement resulting from fraud. particularly the reliability of management representations When the auditor confirms that. The auditor could therefore conclude that proper books of accounts have not been kept where there are too many material errors. Too many errors may also indicate that the system of internal control is not reliable. or error. the auditor should consider whether such a misstatement may be indicative of fraud and if there is such an indication. 7 . If errors are of sufficient magnitude. If during the performance of the audit. the auditor should perform procedures to determine whether the financial statements are materially misstated. and therefore the auditor wishing to place any reliance on a system of internal control may not be able to do so. the auditor should consider the implications for the audit. (b) To obtain knowledge of management‘s understanding regarding the accounting and internal control systems in place to prevent and detect error (c) To determine whether management is aware of any known fraud that has affected the entity or suspected fraud that the entity is investigating (d) To determine whether management has discovered any material errors. the auditor should document the presence of such risk factors and the auditor‘s response to them.(ii) The accounting and internal control systems management has put in place to address such risk. fraud risk factors are identified that cause the auditor to believe that additional audit procedures are necessary. the auditor should consider the auditor‘s responsibility to communicate that information to management. those charged with governance and. the auditor should consider the implications of the misstatement in relation to other aspects of the audit. Procedures When Fraud is suspected When the auditor encounters circumstances that may indicate that there is a material misstatement in the financial statements resulting from fraud or error. or a suspected fraud.

but only disclose those matters where he has a clear public duty to disclose for example. . The auditor should report to management on all actual or potential irregularities and recommendations for changes.Inspect certificates held by third parties e. (vi) Evidence that internal control is not operating as it is intended to. The auditor's responsibility towards fraud and other irregularities is exactly the same as that of errors. evidence is available in the form of: (a) Share certificates. stock brokers to find out whether they are in the name of the client. If the auditor suspects that management is involved in irregularities. brokers. (g) Unduly lavish life styles of employees and officers (vii) Figures not agreeing with expectations. Auditors can also report irregularities to third parties: the auditor should take legal advice or advice from his professional body to ensure the accounts give a true and fair view. (i) Existence and ownership rights and obligations -The auditor should examine certificates of title for investments recorded in the investment records and confirm that they are in the clients name and are free from any charge. (c) Dividends/interest from securities. correspondence with nominee etc (b) Payments for securities. Possible indications of irregularities include: (i) Missing documents or vouchers.g.Irregularities -can be described as intentional distortions of financial statements for whatever purpose and also as misappropriation of assets whether or not a company by distortions of financial statements. listed stocks Since Super face ltd is listed in the Nairobi stock exchange the auditor should carry out the following audit procedures. these could have been deliberately destroyed to conceal an irregularity (ii) Evidence of altered documents: alterations can take place after the transaction has been approved (iii) Unsatisfactory explanation: these are explanations that are vague and are unsupported (iv) Evidence of disputes (v) Existence of suspense accounts or unexplained differences on reconciliations. However. dividends warrants. or contract notes.g. Establishment of title and beneficial ownership of investments is not conclusively possible. (c) Audit procedure on investment e. then he should report to the main board or to the audit committee. 8 . if a serious crime has been committed.

The lower of cost and net realizable value is obligatory. (ii) Valuation Valuation of listed securities is easily conformed to appropriated financial publications. which may mean examining copies of accounts of companies in which investments are held. (g) The auditor must check and confirm the consistency with which the amounts have been computed. Unlisted share income must be verified with copies of the accounts.. Income from securities can be verified with known interest rates for fixed interest securities. the auditor has to consider the suitability of the policies selected by the organization. FIFO or weighted average cost is used to allocate costs. weighted average (c) The auditor should test check the stock sheets or the continuous stock records with relevant documents such as invoices and costing records to determine if cost has been correctly arrived at. iii. and a share information service for listed shares. must therefore be examined. The auditor must also consider whether any write downs for impairment in value are adequate. The proportion included must be based upon the normal level of act ii. 9 .If the company has bought new investments the auditor should confirm whether the purchase was properly authorized by verifying with the contract notes. You must note that under IAS 2 i. -Incase of disposal of investments the auditor should verify the disposal to the sale agreement confirming proper authorization and confirm whether made is computed correctly. (d) The auditor must examine and test the treatment of overheads. Director’s valuation of unlisted securities is something on which the auditor’s report. and the basis of the calculations. (f) The auditor must check the arithmetical accuracy of the calculations made. The cost should where appropriate include a proportion of production overheads whether or not they vary on a time basis. Where identical items are purchased or made at different times and therefore have differing costs the method of arriving at cost should be FIFO. (d)Audit procedures are regards stocks Auditor’s duties as regards stocks can be summarized as follows: (a) Ascertaining the accounting policies adopted by the entity for valuing stocks (b) As the guiding standard on stocks is IAS 2 inventories. (e) The auditor must test the treatment and examine the available evidence for items valued at net realizable value.

cutoff. 10 . (vii) Arranging to obtain from third parties confirmation of stocks held by them. (b) During The main task during stock taking is to ascertain whether the client's employees are carrying out their instructions properly. Record fully the work done and his impression of the stock take exercise. details of defective. He must form a conclusion as to whether the stock take can be relied upon.g.(h) The auditor must consider the adequacy of the description used in the accounts and the disclosure of the accounting policies adopted. He should pay special attention to high value items. Details of items for cut off purposes. during and after. Form a mental impression of the quantity of stock held for comparison with the accounts. It is usually advisable for the auditor to test the efficiency of the counting by counting selected items. (v) Consideration of the location of stocks and likely points of difficulty e. observe and discuss with the store keeping staff the procedures for identifying damaged.t. obsolete or slow moving items. (iii) Familiarization with the nature and volume of stocks and especially with high value items. The auditor should make notes for follow up purposes of items counted in his presence. The auditor’s procedures are covered under three stages. (ii) Familiarization with the location of the stocks and the opportunity to plan for the work to be undertaken. obsolete and slow moving stocks. In this case the auditor should select items for counting from the records and from the factory flow. (viii) Establishing whether expert advice may be needed. Incidence of stock taking instructions not being followed e. before. (c) After It is mainly a follow up exercise and it involves: (i) Checking the cut off with the details of last numbers of stock movement forms and goods inward and goods outward notes during the year and after the year end. damaged. (a) Before (i) Study of the clients stock taking instructions and recommendations for changes or improvements if the auditor considers them inadequate. He must enquire into. He should take photocopies of the rough stock sheets. He should enquire and test the cut off arrangements.c. He should take details of the sequence of the stock sheets. (vi) Consideration of any involvement of the internal audit department and the extent of reliance to be placed upon their work. (iv) Review of previous year’s working papers and discussions with the managers of any significant changes from the previous year.

When litigation or claims have been identified or where the auditor believes they may exist. (iii) Examination of the minutes of the board for references to and indications of possible claims. The request must be sent by the client not by the auditor. (iv) Review of correspondence with solicitors and obtaining a list of all matters referred to solicitors with an estimate of the possible ultimate liability. He must particularly check that all the forms issued were returned. These include: (e) Audit procedure on Pending Litigation (i) Review of the client system for recording claims and disputes and the procedures for bringing this to the attention of the board.(ii) Ensuring that the final stock sheets have been properly prepared from the count records. Because of the inherent uncertainty in estimating the outcome of legal actions. Some actions are possible that assist in verifying the existence but not necessarily the amount of liabilities that will arise out of legal action. casting. (ii) Review of the arrangements for instructing solicitors. It should specify the litigation and management‘s assessment of the outcome. The letter should be prepared by management and sent by the auditor. (v) Written assurance in the form of a representation letter from an appropriate director that he is not aware of any other matters referred to the lawyers other than those disclosed. If the lawyer is likely to respond to a more general enquiry. the auditor should seek direct communication with the entity‘s lawyers. extensions. (iii) Inspection of bills rendered by the solicitors. (iv) Examine legal expense account (vi) Review the client‘s system of recording claims including the procedure for bringing them to the attention of management. and request that the lawyer confirm directly to the auditor the reasonableness of the statement and to provide the auditor with further information if the list is incomplete. (v) Inform the management of any problems in the stock taking exercise so that they can act accordingly. If the auditor is in doubt he should obtain a direct confirmation from the Company's lawyers. (iv) Follow up any notes made and the attendance. then that 11 . (iii) He should check the final stock sheets for pricing. summarization and the necessary improvement. this is an especially difficult area for the auditor.

In addition IAS 37 gives examples of how specific situations should be dealt in terms of recognition. correspondence with customers. a qualified audit opinion will normally follow. (iii) Determine for each material provision and contingency whether it’s probable that the transfer of economic will be required to settle the obligation. (ii) Determine for each material provision which has a present obligation as a result of post events by reviewing correspondences relating to the item and also holding discussions with directors to find out whether they have created a valid expectation with the other party that t would discharge the obligation. IAS 37 requires that (in accordance with the definition of a liability) a provision should be made where the matter gives rise to a constructive or legal obligation and where there is a probability that there will be an outflow of economic benefits which can be reliably measured. Where permission to communicate with lawyers is refused. (f) Audit procedures on Contingent Liabilities IAS 37 A contingent liability is a possible obligation that arises from past events and whose existence will be confirmed by the occurrence of one or more future events which are not in control of the organization. (vi) In an event that is not possible to eliminate the amount of the provision. Management of 12 . (vii) Physically inspect any sites in respect of which clean up restoration provisions have been made (viii) Consider the need for expert technical assistance (xi) Assess the need for further similar provisions (g) Discontinued Operations A discontinued operation is a component of an entity that either has been disposed of or is held for sale. with the client‘s permission and preferably with the client in attendance.lawyers are generally unwilling to do this unless there is nothing to report. It may be a subsidiary. measurement and disclosure depending on the circumstances The specific procedures are as follows: (i)The auditor should obtain details of all provisions and contingent liabilities that have been disclosed and seek supporting documentation in the form of legal opinions. (vi) Recalculate the provisions that have been made. environmental and technical reports. (v) Compare any amounts provided for with any payments made after year end with payments made for similar items. or a major line of business or geographical area. check whether the contingent liability has been reflected in the accounts.would be better . In complex situations the auditor may need to meet the lawyer.

and that they agree that the company‘s disclosures are appropriate.P. Company external audit risk and the complexity of the company Abbott. Srivastava R. References: 1. Appropriate formats must be used for the information to be disclosed.el al (2004) 2. The key auditing matters arising are that the auditors should confirm whether they agree with the company‘s view as to the need for disclosure of proposed or actual discontinuance. Typical procedures would include: (i) Determine the client‘s policies and procedures in respect of discontinuing operations (ii) Review board minutes and other relevant management documentation (iii) Make enquiries of management into significant disposals of assets and investments (iv) Examine after date information (v) Verify the makeup of discontinuing operations by reference to supporting documentation. International auditing by David O’ Regan 4. and also ensuring that lonely appropriate costs are included in any provision for restructuring that is established.Super face ltd is committed a formal plan to discontinue the facsimile assembly division. Modern auditing by Wilham C Baynton 13 .R (1992) Belief function formula for audit risk 3. Audit procedure The accounting and auditing issues are mainly concerned with identifying the point in time at which the initial disclosure even occurs. Some of the audit procedure that should be undertaken is as below. and Shafer G.