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Introduction
The external auditor must assess the level of audit risk when planning an audit as this impacts the
amount and nature of audit procedures they will perform. Consequently, questions on audit risk
feature regularly in the Audit and Assurance (AA) exam.
There are two main types of audit risk questions: knowledge based questions where you need to
explain audit risk and its components (inherent, control and detection risk), and scenario based
questions on audit risk which tend to feature in Section B of the exam.
The Examiner’s reports state that candidates’ performance in Section B questions on audit risk
can often be very mixed. You will be provided with a scenario and the requirement will ask you to
‘Describe (for example) seven audit risks and explain the auditor’s response to each risk in
planning the audit of ABC Co’.
This skills checkpoint will therefore consider how you should approach such questions.

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Skills Checkpoint 2: How to approach audit risk
questions
AA Skill: How to approach audit risk questions
A step-by-step technique for ensuring that your approach to audit risk questions uses the
scenario provided in the exam and maximises your marks is outlined below. Each step will be
explained in more detail in the following sections and illustrated by answering a requirement from
a past exam question.

STEP 1:
Allow some of your allotted time to read the requirements and the scenario.
Don't rush into starting to write your answer.

STEP 2:
Re-read the scenario and start to develop an answer plan.
Use the table headings provided (Audit risk and Auditor's response) and as you
read through the scenario for the second time, write down a few words or a bullet
point each time you identify a potential audit risk in the scenario.
Use these as headings in your answer.

STEP 3:
Re-read the requirement to confirm how many audit risks you need to describe.
You may have written down more headings than required, in which case decide
which ideas you can explain most easily and include those in your answer.
When you write your answer the audit risk should describe the specific impact that
the issue might have on the financial statements (ie a balance could be
under/overstated or a disclosure missing) or the impact on the smooth running of
the audit (ie information may not be available). Next explain the practical steps you
would expect the auditor to take to address the risks.

Exam success skills

The following illustration is based on an extract from a past exam question, about a
pharmaceutical manufacturer, called ‘Abrahams’. This extract was worth 10 marks.
For this question, we will also focus on the following exam success skills:
• Managing information. It is easy for the amount of information contained in scenario based
questions to feel overwhelming. To manage this, focus on the requirement first, noting the key
exam verbs to ensure you answer the question properly. Then, read the rest of the question,
noting important and relevant information from the scenario.
• Correct interpretation of requirements. Here you need to both describe the audit risk and
explain the auditor’s response to each risk.
• Answer planning. Everyone will have a preferred style for an answer plan. For example, it may
be highlighting, bullet-pointed lists, or simply making notes. Choose the approach that you
feel most comfortable with or, if you are not sure, try out different approaches for different
questions until you have found your preferred style.
• Effective writing and presentation. Often, the examining team will specify the format your
answer should take. If you follow this then you stand the best chance of maximising your
marks. You may also wish to use sub-headings in your answer. You could use a separate sub-
heading for each audit risk you identify in the scenario and then go on to explain the impact
that audit risk could have on the financial statements or the smooth running of the audit.

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 Underline or embolden your headings and sub-headings and full sentences, ensuring your
style is professional.
• Good time management. It is essential that you do not overrun on the constructed response
questions in Section B and so you must always keep an eye on time. Note down the time you
should finish the question.

Skill Activity
STEP 1 Allow some of your allotted time to read the requirement and the scenario. Do not rush into starting to write
your answer.
Start by analysing the requirements so that you know what you are looking for when you read the scenario.

Required

(b) Using the information provided, describe FIVE audit risks, and explain the auditor’s response to
each risk in planning the audit of Abrahams Co.
Note. Prepare your answer using two columns headed Audit risk and Auditor’s response
respectively.
10 marks
The first part of the requirement is to ‘describe FIVE audit risks’. Here you need to use the scenario
to generate five issues that could cause a problem in the financial statements or impact the
smooth running of the audit.
Problems in the financial statements could include:
• A balance being over or understated (for example if there is an error in the accounting
treatment or cut-off)
• A disclosure being omitted or misleading (for example relating to a contingent liability)
• Uncertainty relating to going concern (for example loss of a key customer or the impending
renewal of bank loan/overdraft facilities)
• Loss of client accounting information/systems
Events that might impact the smooth running of the audit include:
• The client is a new audit client (so the auditor is less familiar with the client’s business/systems)
• Loss of key client personnel (for example the loss of a finance director/finance officer before
the year-end)
• Whether there are time pressures on the audit or a tight reporting schedule
The second part of the requirement is to ‘explain the auditor’s response to each risk’. This does not
mean that you need to provide a list of audit procedures but rather you should explain the
practical action the auditor would take. For example, what questions should they ask, what
information would they need, what documents would they require access to and which figures
might they recalculate?
This requirement is worth 10 marks and at 1.8 minutes a mark, should take 18 minutes to both plan
and write the solution.

Abrahams
Abrahams Co develops, manufactures and sells a range of pharmaceuticals and has a wide
customer base across Europe and Asia. You are the audit manager of Nate & Co and you are
planning the audit of Abrahams Co whose financial year end is 31 January. You attended a
planning meeting with the finance director and audit engagement partner and are now reviewing
the meeting notes in order to produce the audit strategy and plan. Revenue for the year is
forecast at $25 million.
During the year the company has spent $2.2 million on developing several new products. Some of
these are in the early stages of development whilst others are nearing completion. The finance
director has confirmed that all projects are likely to be successful and so he is intending to
capitalise the full $2.2 million.

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 Once products have completed the development stage, Abrahams Co begins manufacturing
them. At the year-end it is anticipated that there will be significant levels of work in progress. In
addition, the company uses a standard costing method to value inventory; the standard costs are
set when a product is first manufactured and are not usually updated. In order to fulfil customer
orders promptly, Abrahams Co has warehouses for finished goods located across Europe and
Asia; approximately one-third of these are third-party warehouses where Abrahams Co just rents
space.
In September a new accounting package was introduced. This is a bespoke system developed by
the information technology (IT) manager. The old and new packages were not run in parallel as it
was felt that this would be too onerous for the accounting team. Two months after the system
changeover, the IT manager left the company; a new manager has been recruited but is not due
to start work until January.
In order to fund the development of new products, Abrahams Co has restructured its finance and
raised $1 million through issuing shares at a premium and $2.5 million through a long-term loan.
There are bank covenants attached to the loan, the main one relating to a minimum level of total
assets. If these covenants are breached then the loan becomes immediately repayable. The
company has a policy of revaluing land and buildings, and the finance director has announced
that all land and buildings will be revalued as at the year-end.
The reporting timetable for audit completion of Abrahams Co is quite short, and the finance
director would like to report results even earlier this year.
STEP 2 Now you should be ready to re-read the scenario and set out an answer plan using the risks you identify as
you read through.
Use headings.
Work through each paragraph of the scenario identifying specific audit risks. Each risk is worth one mark
and the auditor’s response is also worth one mark, hence why you need five properly explained risks and
responses to gain 10 marks.

Completed answer plan

Having worked through each paragraph, an answer

plan can now be completed. A possible answer plan is
shown here.

Abrahams Co develops, manufactures and sells a range

of pharmaceuticals and has a wide customer base
across Europe and Asia. You are the audit manager of
Nate & Co and you are planning the audit of Abrahams
Co whose financial year end is 31 January. You
attended a planning meeting with the finance director
and audit engagement partner and are now reviewing
the meeting notes in order to produce the audit strategy
and plan. Revenue for the year is forecast at $25 million.

During the year, the company has spent $2.2 million on

developing several new products. Some of these are in
the early stages of development whilst others are
nearing completion. The finance director has confirmed
that all projects are likely to be successful and so he is
1
Risk that intangible assets and profit
intending to capitalise the full $2.2 million1.
may be overstated if IAS 38 PIRATE
criteria not met

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 Once products have completed the development stage,
Abrahams Co begins manufacturing them. At the year-
end, it is anticipated that there will be significant levels
of work in progress2. In addition, the company uses a 2
Risk that work in progress may be
overvalued/difficult to value – do we have
standard costing method to value inventory; the sufficient skills? Expert required?
standard costs are set when a product is first
manufactured and are not usually updated.3 In order to 3
Standard costs used – must be kept up
to date so they approximate to actual
fulfil customer orders promptly, Abrahams Co has costs – inventory may be
over/understated
warehouses for finished goods located across Europe
and Asia; approximately one-third of these are third-
party warehouses where Abrahams Co just rents
space.4 4
Inventory held at third party locations –
any inaccuracies in inventory count may
In September, a new accounting package was lead to material over/understatement.
Which locations should we attend for the
introduced5. This is a bespoke system developed by the inventory count?

IT manager. The old and new packages were not run in

5
New accounting system (and bespoke)
parallel as it was felt that this would be too onerous for
– any errors on transfer of information
the accounting team. Two months after the system could lead to material errors in fs. Testing
required on transfer of balances.
changeover the IT manager left6 the company; a new
6
manager has been recruited but is not due to start work IT manager left, replacement not yet
started. Investigate level of errors
until January. occuring and support available.
Document new internal controls.
In order to fund the development of new products,
Abrahams Co has restructured its finance and raised $1
million through issuing shares7 at a premium and $2.5 7
Share issue – risk that transaction not
properly disclosed in statement of
million through a long-term loan. There are bank changes in equity. Recalculate split
between nominal value and premium.
covenants8 attached to the loan, the main one relating
to a minimum level of total assets. If these covenants are 8
Loan covenants exist – risk that
breached then the loan becomes immediately financing could be recalled if covenants
not met (going concern). Review
repayable. The company has a policy of revaluing9 land covenants to determine whether breach
has occured and bank correspondence.
and buildings, and the finance director has announced
that all land and buildings will be revalued as at the 9
Revaluation may be required to satisfy
year-end. loan covenants – risk that valuation
overstated. Consider status of valuer
(independent/competent).
The reporting timetable for audit completion of
Abrahams Co is quite short10, and the finance director 10
Tight reporting timescale may not
would like to report results even earlier this year. allow enough time to gather sufficient
evidence. Plan to perform work on assets
STEP 3 You will see that there are more than five audit risks, therefore pre year end, use more experienced staff.
choose the five that you can best explain.
Use your headings to write your answer, describe the audit risk in
detail explaining the potential impact on the financial statements. Also remember to explain the practical
steps the auditor would take and the work they would do.
Start each point in a new paragraph.
STEP 4 Suggested solution

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Audit risk — Abrahams Co’s finance director intends to
capitalise the $2.2 million of development expenditure
incurred. This material amount should only be
capitalised if the related product can generate future
profits as set out in IAS 38 Intangible Assets. There is a
risk that at least some of the expenditure does not meet
the criteria. This will mean assets and profits are
overstated11. 11
Here the requirements of the
accounting standard are explained as
Auditor’s response — An analysis12 showing well as the potential impact on the fs

developments costs in relation to each product should 12

Response is to obtain a breakdown of
costs which have been capitalised and
be obtained and reviewed. Testing should be carried out test them to determine whether they
meet the IAS 38 criteria
to ensure the technical and commercial feasibility of
each product and, where it cannot be proven that
future economic benefits will result from the product
developed, the related costs should be expensed.

Audit risk — At the year-end it is anticipated that there

will be significant levels of work in progress, likely to
constitute a material balance. The pharmaceuticals
production process is likely to be complex and the audit
team may not be sufficiently qualified to assess the
quantity and value of work in progress. Therefore, they
may be unable to gain sufficient evidence13 over a 13
Audit risk explains that WIP is a
complex/judgemental area so there is risk
material area of the financial statements. that the balance may be materially
misstated
Auditor’s response — Nate & Co should assess its ability
to gain the required level of evidence and if it is not
sufficient, it should approach an independent expert to
value the work in progress. This should be arranged
after obtaining consent from Abrahams Co’s
management and in time for the year-end inventory
count.

Audit risk — In September, a new accounting package

was introduced. The fact the two systems were not run
in parallel increases the risk that errors occurring during
the changeover were not highlighted, and all areas of
the financial statements could potentially be affected.14 14
New accounting system brings the risk
that data produced by the new system at
Auditor’s response — The new system will need to be the year-end may not be reliable

fully documented15 by the audit team including relevant

controls. Testing should be performed to ensure the

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 closing data on the old system was correctly transferred 15
Action: document new system and test
changeover of data
as the opening data on the new system, and that
transactions have not been duplicated on both systems
and therefore included twice.

Audit risk — The loan has covenants16 attached to it. If 16

Loan covenants pose a going concern
risk if breached and also the potential to
these are breached then the loan would be repayable manipulate fs to ensure breaches do not
occur
straight away and would need to be classified as a
current liability, potentially resulting in a net current
liability position on the statement of financial position. If
the company did not have sufficient cash available to
repay the loan balance the going concern status of the
company could be threatened.

Auditor’s response — Obtain and review (or reperform)

covenant calculations to identify any breaches. If there
are any the likelihood of the bank demanding
repayment will need to be assessed and the potential
impact on the company considered. The need to avoid
breaching the covenants reinforces the audit team’s
need to maintain professional scepticism17 in areas that 17
Response – be alert for potential
manipulation, review covenants for
could be manipulated. evidence of breaches

Audit risk — The already short reporting timetable18 for 18

Risk that short timescale means we
cannot gather all of the evidence that we
Abrahams Co is likely to be reduced. This could increase need to form our opinion
detection risk because there is pressure on the team to
obtain sufficient and appropriate evidence in a shorter
timescale, which could adversely influence judgement
on the size of samples and the extent of work needed.

Auditor’s response — If it is confirmed with the finance

director that the time available at the final audit is to be
reduced then the ability of the team to gather sufficient
appropriate evidence should be assessed. If it is not
realistically possible to perform all the required work at
a final audit then an interim audit19 should take place in 19
Response is to perform work before the
year end to reduce pressure after the
late December or early January to reduce the level of year end
work to be done at the final audit.

Exam success skills diagnostic

Every time you complete a question, use the diagnostic below to assess how effectively you
demonstrated the exam success skills in answering the question. The table has been completed
below for the ‘Abrahams‘ activity to give you an idea of how to complete the diagnostic.

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 Exam success skills Your reflections/observations
Managing information Did you identify audit risks in the scenario?

Correct interpretation of Did you identify that you only need five audit risks and five
requirements (related) auditor’s responses to gain ten marks?

Answer planning Did you draw up an answer plan using your preferred approach
(eg highlighting, bullet-pointed list)?
Did your plan help to create a structure for your answer?

Effective writing and Did you use headings (key words from requirements)?
presentation Did you use full sentences?
And most importantly – did you explain why your points
constituted an audit risk?

Good time management Did you manage to read, plan and write out your solution in the
allotted time?

Most important action points to apply to your next question

Summary
You are likely to see a scenario-based question on audit risk in the exam. You cannot prepare for
every type of business and all audit risks, however you can equip yourself with the skills to
attempt audit risk questions by using the information given in the question to guide the structure
of your answer. A key skill is then applying this back to the given scenario. You will not be able to
pass these questions unless you explain both the audit risk and the auditor’ response. It is
therefore essential that you try to create a practical answer that is relevant to the scenario,
and/or addresses the issues identified in the scenario, instead of simply producing risks/responses
you have learned by heart.
As you move into practising questions as part of your final revision, you will need to practise
taking in information from a scenario quickly (using active reading), accurately understanding the
requirements, and creating an answer plan and a final answer that addresses the requirements in
the context of the scenario.

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