Lesson 5

International standard on auditing 315, states that the auditor should:  “…obtain an understanding of the entity and its environment sufficient to identify and assess the risk of a material misstatement in the financial statements”.

 Business risks  Audit risks

 Business risks result from significant conditions, events, circumstances, actions or inactions that could adversely affect the entities ability to achieve its objectives and execute its strategies. The business risks can itself be split into:

Financial risk Operational risk, and Compliance risk.  Financial risks, for example, could arise because of high borrowings and a rise in interest rates. This will put to business under severe pressure and could increase the risk of material misstatement, perhaps with regardsto going concern problems

 Operational risks could arise from operational errors. The products are made incorrectly, that there might be warranty claims, that there is a loss of reputation or indeed the products simply become old-fashioned and an insufficient investment has been made historically in research and development to have new products coming online

 Compliance risks arises from a failure to comply with regulations, this can mean that the business has got large penalties or fines to pay or it may result in the business been prevented from continuing to trade.

 The risk that the error occurs in the first place, that is inherent risk The risk that the client’s own procedures don’t pick up and correct that error that is known as control risk.

 AR = IR x CR x DR Where  AR= Audit Risk  IR=Inherent Risk  CR=Control risk  DR=Detection Risk

 is the risk that there is a misstatement that could be material, if there were no related internal controls which could identify and trap that misstatement.  Inherent risks can be increased by complex transactions which are difficult to understand, inexperience staff, a cash-based business (because cash is usually more difficult to record that bank transfers) a pressure to perform which may mean that some staff memberswho have optimistic view of sales and costs, and short reporting deadlines.

is a risk that the material misstatement, having occurred, will not be prevented, detected, or corrected by the internal control system. The three elements which affect control risk are the control environment (that is really the status that the internal control system has in the organization), the design of the internal control system itself, and finally how well and consistently the internal control system operates

is the failure of the auditor to detect the material misstatement in the financial statements. This will be increased if the auditor was relatively inexperienced, if it was a new client, if there was a lot of time and fee pressure, if planning was poor so the entity was poorly understood, and if the auditor was staying into an industry where they had little previous experience or expertise.

 Sampling risk arises because, in most audits, auditors only look at a very small proportion of transactions and documents.  There is always a risk that they happen to look at all the documents and transactions which are correct and don’t find any which are incorrect.  That can just be bad luck in sampling and could lead the auditor to do too little work. Sampling risk can be reduced by examining larger samples.

 Non-sampling risk arises from reasons other than sampling. For example, if the staff and the audit were inappropriately qualified then there is a high risk because they wouldn’t properly understand what was going on or detect the regularities in the financial statements.  Non-sampling risk can be reduced by better planning of the audit, and ensuring that audit staff are better trained, have appropriate skills and are that their work is well-supervised and reviewed

Audit risk has to be reduced to an acceptable amount of both the Financial statement level Assertion levels.

 Dealing first with the assertion level, essentially any single figure which appears in the financial statements is making an assertion is saying something about its size, its accuracy, its valuation  for example, director’s emoluments

 Dealing with the financial statement level, all the figures appearing in the financial statements could be true, but overall the financial statements could still not show a true and fair view.  For example, liquidity issues could be concealed or in some way the overall effect of the accounts is to be misleading.