1. CHAPTER 4 RISK ASSESSMENT II Prepared by: Daniella Juric RMIT University

2. LEARNING OBJECTIVES AFTER READING THIS CHAPTER YOU SHOULD BE ABLE TO:
Evaluate audit risk
Outline the concept of materiality
Discuss how an auditor determines their audit strategy
Interpret how clients measure performance
Specify how an auditor uses analytical procedures when assessing risk.

3. AUDIT RISK
AUDIT RISK is the risk that an auditor expresses an inappropriate audit opinion when a financial report is materially misstated (ASA 200; ISA 200)
This means the auditor gives an opinion that the financial report is true and fair when it contains a significant error or fraud
Audit risk can never be zero
Audit risk is reduced during risk response phase by identifying the key risks and adjusting audit effort accordingly
LEARNING OBJECTIVE 1: EVALUATE AUDIT RISK

4. AUDIT RISK STAGES IN AUDIT RISK MINIMISATION ASSESS INHERENT RISK
Identification of accounts and related assertions most at risk of material misstatement
Assertions are statements made by management about recognition, measurement, presentation and disclosure of items in financial report and notes
All inventory items stated on balance sheet actually exist

5. AUDIT RISK Fraud Risks are more significant when they involve:
Complex transactions
Risks are more significant when they involve:
significant transactions outside the client’s normal course of business
Significant related party transactions
related to significant economic or accounting developments
significant subjectivity in measurement of financial information

6. AUDIT RISK ASSESS CONTROL RISK
Assessment of client’s system of internal controls
AUDITOR PLANS TO UNDERTAKE DETAILED TESTING OF EACH IDENTIFIED ACCOUNT
Based on auditor’s assessments of riskiness of account and related assertions, and effectiveness of the client’s system of internal controls

7. AUDIT RISK AUDIT RISK MODEL
INHERENT RISK
(IR)
AUDIT RISK (AR)
DETECTION
RISK (DR)
CONTROL
RISK (CR)
Audit risk is a function of:
INHERENT RISK
Risk that a material misstatement could occur
CONTROL RISK- auditor cant influence this risk. Only management can influence bc they run the business. Auditor can only assess this risk by collecting data
Risk that client’s system of internal controls will not prevent or detect such a material misstatement
DETECTION RISK- auditor can infuence this risk
Risk that the auditor’s testing procedures will not be effective in detecting a material misstatement, should there be one.
Taken together, an auditor must identify client characteristics that place its financial report at risk of material misstatement (inherent risk) and determine whether
controls designed to limit such a risk exist and are effective (control risk). Inherent risk and control risk are the client’s risks and exist separately from the audit of the financial
report. An auditor will set their detection risk in response to the assessed client inherent and control risk combined (the risk of material misstatement). Detection risk is the risk
that the auditor’s testing procedures will not be effective in detecting a material misstatement should there be one. It is impossible to reduce detection risk to zero. Detection risk
is set at a level that allows an auditor to achieve a low audit risk, given the client’s risk of material misstatement.

8. AUDIT RISK
Auditor will plan and perform their audit to reduce audit risk to an acceptably low level (ASA 200; ISA 200)
There is an inverse relationship between IR and CR and DR
AUDIT RISK
HIGH INHERENT RISK
HIGH CONTROL
RISK
LOW
DETECTION RISK
AUDIT RISK
LOW INHERENT RISK
LOW
CONTROL
RISK
HIGH
DETECTION RISK

9. MATERIALITY
Materiality guides audit planning, testing, and assessment of information in financial report
Information is material if it impacts on the decision-making process of users of the financial report
LEARNING OBJECTIVE 2: OUTLINE THE CONCEPT OF MATERIALITY

10. MATERIALITY
Information could be considered material because of its qualitative or quantitative characteristics
QUALITATIVE MATERIALITY
NATURE OF THE ITEM
Fraud
Non-compliance with laws
Related party transactions
Change of accounting methods
QUANTITATIVE MATERIALITY
MAGNITUDE OF ITEM
Set as a % of relevant base

11. MATERIALITY SETTING MATERIALITY Auditor uses professional judgement
Audit firms vary in methods to set materiality percentages in the risk assessment phase to derive at an appropriate base percentage
Balance sheet bases include total assets or equity
Income statement bases include profit before tax, revenue or gross profit
Setting lower materiality level during planning increases quality and quantity of evidence required to be gathered
Setting the materiality is different from determining what accounts are material based in qualitative or quantitative measures
Setting

12. AUDIT STRATEGY
AUDITOR MUST ESTABLISH AN OVERALL AUDIT STRATEGY (ASA 300; ISA 300)
Sets scope, timing, and direction of the audit
Provides basis for developing detailed audit plan
Is based on preliminary assessments of IR and CR
LEARNING OBJECTIVE 3: DISCUSS HOW AN AUDITOR DETERMINES THEIR AUDIT STRATEGY

13. AUDIT STRATEGY AUDIT RISK INHERENT RISK CONTROL RISK DETECTION RISK
HIGH RISK CLIENT
HIGH
LOW
AUDIT STRATEGY
No (or very limited)
tests of controls
Increased reliance
on substantive tests
of transactions and
account balances
AUDIT RISK
INHERENT RISK
CONTROL RISK
DETECTION RISK
LOW RISK CLIENT
LOW
HIGH
AUDIT STRATEGY
Increased reliance on
tests of controls
Reduced reliance
on substantive tests
of transactions and
account balances

14. ANALYTICAL PROCEDURES, DETAIL TRANSACTIONS, DETAIL BALANCES

15. AUDIT STRATEGY FIGURE 4.5 The process used when
developing an audit strategy
for risks identified
Flow of transactions:

16. CLIENT PERFORMANCE MEASURES
As part of gaining understanding of client, auditor should learn how client measures its own performance
Client uses key performance indicators (KPIs) to monitor and assess its performance and staff performance, and KPIs can be written into contracts between client and others
Auditor needs to understand what client focuses on, and what is potentially at risk of misstatement
LEARNING OBJECTIVE 4: INTERPRET HOW CLIENTS MEASURE PERFORMANCE

17. CLIENT PERFORMANCE MEASURES
PROFITABILITY
Profit by division, branch, manager etc
Price earnings ratio (P/E)
Earnings per share (EPS)
Decline could signal pressure on management
Cash Earning per share (CEPS)
Inventory turnover
Decline could signal overvalued stock

18. CLIENT PERFORMANCE MEASURES
LIQUIDITY
Ability of company to meet its cash needs in short and long term
Ratios can be written into debt contracts (as covenants) and restrict client’s actions
Client potentially under pressure to misstate accounts included in ratios

19. ANALYTICAL PROCEDURES
Evaluation of financial information by studying plausible links among both financial and non-financial data (ASA 520; ISA 520)
Identify fluctuations in accounts that are inconsistent with auditor’s expectations based on their understanding of the client
Analytical procedures can be conducted throughout audit
Risk assessment phase – risk identification
Risk response phase – estimating account balances
Reporting – overall review
LEARNING OBJECTIVE 5: SPECIFY HOW AN AUDITOR USES ANALYTICAL PROCEDURES WHEN ASSESSING RISK

20. ANALYTICAL PROCEDURES
Highlight unusual fluctuations in accounts
Risk Assessment Phase
Analytical Procedures
Risk Assessment Phase
Analytical Procedures
Aid in risk identification
Identify accounts at risk of material misstatement
Enhance the understanding of the client

21. ANALYTICAL PROCEDURES
COMMON ANALYTICAL PROCEDURES
SIMPLE COMPARISONS
Account balance with previous year, budget
TREND ANALYSIS (HORIZONTAL ANALYSIS)
Comparison of account balances over time
Select base year, restate all accounts in subsequent years as a % of that base
For both techniques, auditor should factor in client and economic changes, and form expectations of reasonable changes in balances over time

22. ANALYTICAL PROCEDURES
2012
2013
2014
2015 $M %
INCOME STATEMENT ITEMS
Sales
250
(20)
(10) 20
Cost of Sales
110 10
Interest Expense
(30) 30
Wages Expense 70 6
Rent Expense 40
BALANCE SHEET ITEMS
Cash
400 25
Inventory
350
Trade Receivables
300 5 15
Figure 4.6 provides an example of a trend analysis.

23. ANALYTICAL PROCEDURES
COMMON ANALYTICAL PROCEDURES
COMMON-SIZE ANALYSIS (VERTICAL ANALYSIS)
Comparison of account balances to single line item
Balance sheet – express each item as % of total assets
Income statement – express each item as % of sales
Using analysis over several years, auditor can see how each account contributes to totals, and how this changes over time

24. ANALYTICAL PROCEDURES
2012
2013
2014
2015 $M %
INCOME STATEMENT ITEMS
Sales
100
Cost of Sales 44 50 48 40
Interest Expense 4 6 3
Wages Expense 28 22 25
Rent Expense 16 20 18 13
BALANCE SHEET ITEMS
Cash 5
Inventory 27 23
Trade Receivables
Payables 15 17
TOTAL ASSETS
Figure 4.7 provides an example of a common-size analysis.

25. ANALYTICAL PROCEDURES
COMMON ANALYTICAL PROCEDURES
RATIO ANALYSIS
Assess relationship between various financial report balances, and between them and non-financial items
Profitability ratios
Liquidity ratios
Solvency ratios

26. ANALYTICAL PROCEDURES
PROFITABILITY RATIOS
LIQUIDITY RATIOS
SOLVENCY RATIONS
RATIO
DEFINITION
Gross Profit Margin
Gross Profit
Net Sales
Current Ratio
Current Assets
Current Liabilities
Debt to equity ratio
Liabilities
Equity
Profit Margin
Profit
Quick Ratio
Cash + Short-term investments + Receivables (net)
Current liabilities
Times interest earned
Profit before income taxes and Interest expense
Interest expense
ROA
Average Assets
Inventory
Turnover
Cost of Sales
Average Inventory
Return on Shareholder’s equity
Average Equity
Receivables
Net credit sales
Average net receivables

27. ANALYTICAL PROCEDURES
INTERPRETING RESULTS OF RATIO ANALYSIS
Compare results to previous years’, budgets, competitors
Discuss significant variation with management
Consider effects on future viability of company (going concern risk)
Lack of variation in results could be unexpected if conditions have changed
Where results are unusual or unexpected, investigate further because it indicates risk of material misstatement

28. ANALYTICAL PROCEDURES
FACTORS TO CONSIDER WHEN CONDUCTING ANALYTICAL PROCEDURES
Has client data been audited? Is external data reliable?
Poor controls would signal higher risk in relying on analytical procedures
Change in accounting methods could distort data
Auditor may have access to half-year results only
Reliability of budget setting process – is client continually missing budgeted targets?
Are industry comparisons valid?

29. SUMMARY AFTER READING THIS CHAPTER YOU SHOULD BE ABLE TO:
Evaluate audit risk
Outline the concept of materiality
Discuss how an auditor determines their audit strategy
Interpret how clients measure performance
Specify how an auditor uses analytical procedures when assessing risk.
SUMMARY
1. Evaluate audit risk.
Audit risk is the risk that an auditor expresses an inappropriate audit opinion when a financial report is materially misstated. The three components of audit risk are inherent risk, control risk and detection risk.
2. Outline the concept of materiality.
Information is considered to be material if it impacts the decision-making process of users of the financial report.
3. Discuss how an auditor determines their audit strategy.
The audit strategy is a key component of the risk assessment phase of the audit. It sets the scope, timing and direction of the audit and provides the basis for developing a detailed audit plan. An audit strategy will depend upon the auditor’s preliminary inherent and control risk assessment.
4. Interpret how clients measure performance.
The review of the different ways that clients measure their own performance was included in this chapter to highlight that by understanding how a client measures its
own performance an auditor can plan their audit to take into consideration areas where their client may be under pressure to achieve certain outcomes.
5. Specify how an auditor uses analytical procedures when assessing risk.
Analytical procedures are conducted at the risk assessment phase of the audit to identify unusual fluctuations, help identify risks, help when gaining an understanding
of a client, identify the accounts at risk of material misstatement and reduce audit risk by concentrating audit effort where the risk of material misstatement is greatest. There are many processes that can be used when conducting analytical procedures. The processes discussed in this chapter included simple comparisons, trend analysis, common size analysis and ratio analysis.