Chapter 5 Risk assessment

1. the sources of risk

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’

The total risk of material misstatement can be split into two:

A. _______________________
B. ______________________

A. Business risks

______________________-

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.

_______________________

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.

________________________

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 auditor does not have a responsibility to identify or assess all business risks, but
an understanding of business risks increases a likelihood of identifying risks of
material misstatement.

B. Audit risks

That is a risk that the auditor gives an _____________________ on the financial

statements. For example, the audit report states the financial statement show a true
and fair view when in fact they contain a ____________________________.

Audit risk has two major components. One is dependent on the entity, and is the risk
of material misstatement arising in the financial statements
(____________________________). the other is dependent on the auditor, and is
the risk that the auditor will not ______________material misstatements in the
financial statements (detection risk). audit risk can be represented by the audit risk
model:

Audit risk = inherent risk *control risk *detection risk

___________________________--is the risk that the error occurs in the first place. It
is the risk that items will be misstated due to the characteristics of those items, such
as the fact they are estimated or that they are important items in the accounts.

____________________________ is the risk that the client’s own procedures don’t

pick up and correct that error.

____________________________--- is the risk of not detect a misstatement that

exists and that could be material. One way to decrease the detection risk is to
increase sample sizes. Detection risk is higher if the client are the new client which
the auditor are not familiar with.

Auditors will want the audit risk to be _______________; they don’t want to make
an error in their audit opinion. If you want the audit risk to be low then the terms on
the right hand side of the equation have to be low.
Auditors will want their overall audit risk to be at an acceptable level, or it will not
be worth them carrying out the audit. In other words, if the chance of them giving
and inappropriate opinion and being sued is high, it might be better not to do the
audit at all.
The auditors will obviously consider how risky a new audit client is during the
acceptance process and my decide not to go ahead with the relationship.

As we have seen above , it is not in the auditors power to affect inherent or control
risk. These are risks integral to the client, and the auditor cannot change the level of
these risks. The auditors therefore manage overall audit risk by manipulating
detection risk, the only element of audit risk they have control over. This is because
the more audit work the auditors carry out, the lower detection risk becomes.

Audit firms are likely to charge higher fees for higher risk clients.

Example of risks Possible response

Risk that inventory has a lower net Increase the emphasis on reviewing the
realizable value than cost and is therefore year end ages inventory analysis for
overstated evidence of slow moving inventory.
Exp: NRV fall due to the client being in Change the NRV
an industry where tastes/ fashions change
quickly
Assets are desirable/more susceptible to Physical controls to prevent theft
theft leading to a risk that recorded assets
do not exist
Exp; inventory
Increased risk of revenue expenditure Review the asset register to ensure only
being incorrectly classified as capital capital item have been included.
leading to misstatement of assets and
expenses
Exp: extensive refurbishment of non
current assets where judgment is needed
to establish whether the nature of the
work is to enhance the asset or repair it
Increased risk of incomplete or If a retail client, perform reconciliation of
unrecorded income due to fraud or theft a sample of till records to actual banking.
Exp’ large amounts of cash collected and
held prior to banking
Receipts/invoicing significantly in Trace back supporting document to test
advance or arrears of providing services that revenue was recorded in the proper
lead to increased risk of revenue being in period.
the wrong period
Exp; deposits received in advance,
There is an increased risk of irrecoverable Review aged receivable analysis to
debts resulting in assets being potentially consider adequacy of any related
overstated. receivables allowance.
Exp; due to the nature of the clients
industry
Significant client borrowing and Review the cash flow forecasts for
overdraft with cash flow problems which evidence the company can continue as a
may indicate going concern problems going concern
New client / new staff/ new system Perform extra work to document and
increasing the risk of errors increase the sample sizes for substantive
testing
Management has an incentive to testing on judgmental areas in
manipulate performance remuneration
Exp; remuneration

Example 1:

Hippo Co is a long established client of your firm. It manufactures bathroom fittings

and fixtures, which it sells to a range of wholesalers, on credit. You are the audit
senior and have recently been sent the following extract from the draft statement of
financial position by the finance director.

Budget Actual
Non current assets 453000 36700
0
Current assets
Trade accounts receivable 1134000 976000
bank - 54000
Current liability
Trade accounts payable 967000 944000
 Bank overdraft 9000

During the course of your conversation with the finance director, you establish that a
major new customer the company had included in its budget went bankrupt during
the year

Required:
Identify any potential risks for the audit of Hippo and explain why you believe they
are risks
a
Practice question:
1. Complete the definitions.
_______________ risk is the risk that ________________s may give an inappropriate
opinion on the financial statements.

2. Minty Cola manufactures fizzy drinks such as cola and lemonade as well as other
soft drinks and its year end is 21 December 2013. you are the audit manager of
Parsly & Co and are currently planning the audit of Minty. You attended the planning
meeting with the engagement partner and finance director last week and recorded
the minutes form the meeting shown below. You are reviewing these as part of the
process of preparing the audit strategy.

Minutes of planning meeting for Minty

Minty’s trading results have been strong this year and the company is forecasting
revenue of $85 million, which is an increase from the previous year. The company
has invested significance in the cola and fizzy drinks production process at the
factory. This resulted in expenditure of $5 million on updating, repairing and
replacing a significant amount of the machinery used in the production process.

As the level of production has increased, the company has expanded the number of
warehouses it uses to store inventory. It now utilizes 15 warehouses; some are
owned by Minty and some are rented from third parties. There will be inventory
counts taking place at all 15 of these sites at the year end.

A new accounting general ledger has been introduced at the beginning of the year
with the old and new systems being run in parallel for a period of two months.

As a result of the increase in revenue, Minty has recently recruited a new credit
controller to chase outstanding receivables. The finance director thinks it is not
necessary to continue to maintain an allowance fore receivables and so has released
the opening allowance of $1.5 million

In addition, Minty has incurred expenditure of $4-5 million on developing a a new

brand of fizzy soft drinks. The company started this process in January 2013 and is
close to launching their new product in to the market place
The finance director stated that there was a problem in November in the mixing of
raw materials within the production process which resulted in a large batch of coal
products tasting different. A number of these products were sold, however due to
complaints by customers about the flavor, no further sales of these goods have been
made. No adjustment has been made to valuation of the damaged inventory, which
will still be held at cost of $1 million at the year end.

As in previous years, the management of Minty is due to be paid a significant annual

bonus based on the value of year end total assets.

Required:
A. Explain audit risk and the component of audit risk
B. Busing the minutes provided, identify and describe six audit risks and explain
the auditors response to each risk