AUDIT RISK

09 December 2020 21:03

Introduction
• Reasonable Assurance
○ FS are free from material misstatements
○ There is some degree of risks that the auditor did not detect all material misstatement
• In opinion para; FS present fairly "in all material aspects"
○ This communicates to the 3rd parties that the audit report is limited to material information
Relationship : inverse relationship between audit risk and materiality, and between the desired level of audit risk and the
amount of audit evidence the auditor must collect.

AUDIT RISK
• Audit Risk simply means that there is a possibility that the auditor issues an inappropriate audit opinion.
• audit risk is the risk that an auditor will issue an unqualified opinion on materially misstated financial statements
• (ISA 200, para 13 (c)) states that it is the risk that the auditor expresses an inappropriate audit opinion when the
financial statements are materially misstated.
○ audit risk does not include the risk that the auditor might express an opinion that the financial statements are
materially misstated when they are not. This risk is ordinarily insignificant. This explanatory paragraph note is
different with ISA 200, para 13 (c) as stated above
• AR is a function of RMM and DR.
• The assessment of risk is based on audit procedures to obtain information necessary for that purpose and evidence
obtained throughout the audit. (ISA 200, para 34)
○ It is the matter of professional judgement
• Audit risk is a function of the risks of material misstatement (RMM) and detection risk (DR).
• Audit Risk Model
 IR X CR = RMM = Client Risk
AR = [IR X CR] + DR; AR = RMM + DR  Not under the auditor's control
 DR is a residual risk
(component of AR)  more samples
 Increased workload
• AR =/= Auditor's Business Risk
• Auditor's Business Risk (ISA 200, A35) such as loss from litigation, adverse publicity, or other events arising in
connection with the audit of financial statements.
• Material Misstatement
○ Fraud
○ Intentional - involve management because hard to uncover & it is costly
▪ Misappropriation of assets
▪ Fraudulent Financial Reporting
▪ Criminal breach
○ Error
○ Unintentional
• ISA 200 (A36); The risks of material misstatement [RMM] may exist at two levels:
1. The overall financial statement level; and (further explanation A37)
○ refer to RMM that relate pervasively to the FS as a whole and potentially effect many assertions
2. The assertion level for classes of transactions (further explanation A38)
○ To determine the nature, timing and extent of further audit procedures necessary to obtain sufficient
appropriate audit evidence
○ The evidence will allow the auditors to express an opinion on the FS at acceptably low level of audit risk.
Article discussed: "Client's Acceptance Decisions...." by Karla M Johnstone, 2000)
• Scope of audit (3):
○ Nature:
▪ type of evidence
○ Timing:
▪ refers to when the evidence will be gathered
○ Extent:
▪ How much of the type of evidence will be evaluated

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• Audit risk levels:

○ Overall financial statement level (as a whole)
○ Significant account and disclosure through a focus on the relevant assertion identified
▪ significant account or disclosure is an account or disclosure that has a reasonable possibility of
containing a material misstatement regardless of the effect of internal controls.
▪ relevant assertion is a management assertion that has a reasonable possibility of containing a material
misstatement without regard to the effect of internal controls:
□ consideration of audit risk at the assertion level means that the auditor must consider the risk
that he or she will conclude that an assertion for:
▫ a particular account balance (e.g., existence of accounts receivable),
▫ a particular class of transactions (e.g., classification of capital lease transactions), or
▫ a particular disclosure (e.g., valuation of amounts disclosed in a footnote dealing with stock
compensation) is fairly stated, when in fact it is materially misstated
• Audit risk is the combination of these two elements —
1. that the client’s financial statements will contain material misstatements and
2. that the auditor will fail to detect any such misstatements.

ENGAGEMENT RISK
• Auditors have to be selective in accepting new audit client or retaining existing audit client. This is an
important first step that must be well decided upon. Here, the concept of engagement risk is being explained
and it is very crucial for the auditors to evaluate the factors because failing to do so would lead to what we
call as "Reputational Risk".
• identify factors affecting the engagement risk.
▪ Client's business risk
▪ Audit risk
▪ Auditor's business risk (engagement risk)
• identify factors affecting the decision making of accepting and retaining clients
▪ Integrity of the management
▪ Consider previous experiences with the entity and changes the client has recently made that are
particularly significant − include rapid modification of operation, altered management behaviour
▪ Consider the combination findings from applying various procedures when making the decision −
negative findings:
□ Heightened auditor's scepticism
□ increase the assessment of auditor's business risk and thus engagement risk.
○ Example: An example see news https://www.accountancydaily.co/rolls-royce-hires-pwc-ps59m-audit
• ISA 210, Para 6: Preconditions of an Audit
○ Auditors should screen clients to ensure they are not high risk
○ The risk to the auditor is ‘reputation risk’ (i.e. that they will be associated with a poorly regarded
client.)
○ Is the FR framework acceptable?
▪ Consider the entity & the purpose of the FS
▪ and laws which say which FR framework should be used
○ Do Management accept their responsibilities?
▪ There must be an agreement:
□ For preparing FS
□ For internal controls
□ For giving the auditor all relevant information they request
○ If the precondition does not present: The auditor shall not accept the proposed audit engagement
• ISA 210, Para 7: Limitation on Scope
○ management imposed a limitation — that will result in auditor disclaiming an opinion: don't accept
engagement
• ISA 210, Para 8: Other Factors Affecting Audit engagement acceptance
• Inverse relationship with AR = ↑ Engagement Risk, ↓ AR (higher level of potential risk to the audit firm

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MATERIALITY
1. explain the materiality concept.
Materiality = quantity and quality
Both the amount (quantity) and nature (quality) of misstatements are relevant to deciding what is material.
▪ Materiality relates to both the content of the financial statements and the level and type of testing to be
done.
▪ The decision is based on judgements about the size, nature and particular circumstances of
misstatements (or omissions) that could influence users of the financial reports.
▪ In addition, the decision is influenced by legislative and regulatory requirements and public expectations.
2. identify the inverse relationship between materiality and audit risk!!.
AR = RMM ↑ X DR ↓ Materiality ↓ [DR and Materiality — relates to workload of the auditor]
STANDARD USED: ISA 315 (R), ISA 300, ISA 320, ISA 330
ISA 320 defines information as material if ‘its omission or misstatement could influence the economic
decisions of users taken on the basis of the financial statements.’
• Material items could be large transactions or significant events.
• Materiality is important to the auditor because if a material item is incorrect, the financial statements will not
show a ‘true and fair view.’
• Materiality level
▪ The auditor will decide materiality levels and design their audit procedures to ensure that the risk of
material misstatements is reduced to an acceptable level.
▪ Generally, materiality will be set with reference to the financial statements such as:
○ 0.5 – 1% of turnover
○ 5 – 10% of profits reported
○ 1 – 2 % of gross assets
▪ Judgement will be used by the auditor in charge and will depend on the type of business and the risks it
faces.
• Considerations
Needs to consider both quantitative and qualitative factors
○ Quantity: The relative size of the item
○ Quality: This might be something that's low in value but could still affect users' decisions e.g.. Directors
wages
○ Tolerable error:
▪ This is when the auditor accepts the error
▪ For example finding one error out of 100 tested, might be ignored
▪ The tolerable level will be decided at planning stage
• Performance Materiality
○ This is lower than normal materiality
○ The idea is that this will try to prevent all those small, undetected errors do not aggregate to become
material
○ There are 2 standards to consider:
▪ ISA 320 Audit Materiality
▪ ISA 450 Evaluation of Misstatements Identified During the Audit
○ As we know, materiality is calculated at the planning stage
▪ But it might not stay at that amount - oh no baby
▪ Things happen that make the auditor change the level
▪ Such things are often immaterial in quantity but material by their nature
○ The new standard recognises that there could well be instances where certain classes of transactions,
account balances or disclosures might be affected by misstatements which are less than the materiality
level for the financial statements as a whole, but which may well influence the decisions of the user of
those financial statements regardless of the fact they are below materiality – this is where performance
materiality is to be applied.
○ Needs to consider both quantitative and qualitative factors

• Arm's length transaction

○ Both buyer and seller don't have/not able to exercise or influence the price
○ A fair dealing/transaction — an effective capital market will be able to dictate the price
• Accounting estimates: involves a lot of (professional) judgement
PROFILING: Management
Whether their lifestyle commensurate with their salary

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