Classification: Internal

4. Risk
• Audit risk is the risk that the auditor expresses an inappropriate audit
opinion when the
financial statements are materially misstated
• Stated another way, this is the risk that there is a material misstatement
in the financial
statements, but the auditor misses it and says that they present a true
and fair view.
• 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
an inappropriate
opinion and being sued is high, it might be better not to do the audit at
all.
• Formula for audit risk is:
Inherent Risk × Control Risk × Detection Risk
ROMM
Inherent Risk
This will be considered at the planning meeting as it depends on the
auditors’ knowledge of the
business. It’s the risk of material misstatements in FS due to the
characteristic and nature of the
business.
Example:
• A cash – based business – TOC
• Fast moving Industry (IT\fashion\food) – risk of obsolete inventory
- expert advice on the valuation of inventory, or
- review post year-end sales to ensure the goods are sold for more than
they are valued at in the
financial statements.
• Domination by a single individual
• Changes in management\staff

Competitive conditions, regulatory requirements, technology

developments
• Tight deadlines
• Estimates
• Complex accounts
• Weak control environment
• Scale, diversity, complexity of business
Control Risk
This is the risk of material misstatement due to inadequate internal
Classification: Internal

controls within the business.

The auditor will make a judgement as to the suitability and strength of
internal controls
Examples
• No segregation of duties
- Segregation of duties is where different tasks in a process are performed
by different people
e.g. an invoice is raised by one person and the cheque is written by
another and authorise by
someone else.
- If this control is weak or not in place, the auditor may have to increase
the sample size to
ensure the financial statements present a true and fair view.
• No controls over access to assets
- If employees have unfettered access to the assets of the business with
no restrictions, this will
increase the risk of theft or damage to those assets.
- If the auditor finds this to be the case, more physical checks of the
existence and condition of
assets will have to be carried out.
• No controls over access to IT
- If a business does not use passwords and other protection to protect its’
computer systems
this can lead to data loss or manipulation without authorisation.

If these controls are not in place the auditor will have to understand the
system to assess the
ease of which it can be manipulated and check for anomalous trends
using analytical review.
Detection Risk
This is the risk that the work carried out by the auditor does not uncover a
material misstatement
that exists. This is the component of audit risk where auditor has a degree
of control over, because
if risk is too high to be tolerated, the auditors can carry out more work to
reduce this aspect of
audit risk and, therefore, audit risk as a whole. Ways to decrease detection
risk is to
• Increase sample sizes
• Adequate planning
• Assignment of more experienced personnel to the engagement team
• The application of professional scepticism
• Increased supervision and review of the audit work performed
Classification: Internal

Detection risk can be split into sampling & non-sampling risk

• Non-sampling risks
- The auditor did not sufficiently investigate a significant balance
- The procedures used may have been inappropriate or misinterpreted
• Sampling risk
- `arises from the possibility that the auditor’s conclusion, based on a
sample may be different
from the conclusion reached if the entire population were subjected to the
same audit
procedure’.
- This is another way of saying that the sample selected by the auditor
was not representative
of the data.
Detection risk may be increased by things such as inexperienced audit
staff or tight deadlines to
complete the audit.

01. (December 2015)

You are an audit supervisor of Pluto & Co and are currently planning the
audit of your
client, Venus Magnets Co (Venus) which manufactures decorative
magnets. Its year end is 31
December 2015 and the forecast profit before tax is $9.6 million.
During the year, the directors reviewed the useful lives and depreciation
rates of all classes
of plant and machinery. This resulted in an overall increase in the asset
lives and a reduction in
the depreciation charge for the year.
Inventory is held in five warehouses and on 28 and 29 December a full
inventory count
will be held with adjustments for movements to the year end. This is due
to a lack of available
staff on 31 December. In October, there was a fire in one of the
warehouses; inventory of $0.9
million was damaged and this has been written down to its scrap value of
$0.2 million. An
insurance claim has been submitted for the difference of $0-7 million.
Venus is still waiting to
hear from the insurance company with regards to this claim, but has
included the insurance
proceeds within the statement of profit or loss and the statement of
financial position.
The finance director has informed the audit manager that the October and
Classification: Internal

November bank
reconciliations each contained unreconciled differences; however, he
considers the overall
differences involved to be immaterial.
A directors’ bonus scheme was introduced during the year which is based
on achieving a

target profit before tax. In order to finalise the bonus figures, the finance
director of Venus would
like the audit to commence earlier so that the final results are available
earlier this year.
Required: Describe FIVE audit risks, and explain the auditor’s response to
each risk, in
planning the audit of Venus Magnets Co.
02. (December 2014)
Is the following statement true or false?
Audit risk is a function of two components, inherent risk and control risk.
A. True
B. False

03. (December 2014)

You are the audit supervisor of Seagull & Co and are currently planning the
audit of your
existing client, Eagle Heating Co (Eagle), for the year ending 31 December
2014. Eagle
manufactures and sells heating and plumbing equipment to a number of
home improvement
stores across the country.
Eagle has experienced increased competition and as a result, in order to
maintain its current
levels of sales, it has decreased the selling price of its products
significantly since September
2014. The finance director has informed your audit manager that he
expects increased inventory
levels at the year end.
He also notified your manager that one of Eagle’s key customers has been
experiencing
financial difficulties. Therefore, Eagle has agreed that the customer can
take a six-month payment
break, after which payments will continue as normal. The finance director
does not believe that
any allowance is required against this receivable.
In October 2014 the financial controller of Eagle was dismissed. He had
been employed
Classification: Internal

by the company for over 20 years, and he has threatened to sue the
company for unfair dismissal.
The role of financial controller has not yet been filled and so his tasks
have been shared between
the existing finance department team.
In addition, the purchase ledger supervisor left in August and a
replacement has been
appointed in the last week. However, for this period no supplier statement
reconciliations or
purchase ledger control account reconciliations were performed. You have
undertaken a
preliminary analytical review of the draft year to date statement of profit
or loss, and you are
surprised to see a significant fall in administration expenses.
Required: Explain FIVE audit risks, and the auditor’s response to each risk,
in planning
the audit of Eagle Heating Co.
04. December 2011
Explain the components of audit risk and, for each component, state an
example of a factor
which can result in increased audit risk. (6 marks)

05. (June 2015)

You are the audit supervisor of Maple & Co and are currently planning the
audit of an
existing client, Sycamore Science Co (Sycamore), whose year-end was 30
April 2015. Sycamore
is a pharmaceutical company, which manufactures and supplies a wide
range of medical supplies.
The draft financial statements show revenue of $35.6 million and profit
before tax of $5.9 million.
Sycamore’s previous finance director left the company in December 2014
after it was
discovered that he had been claiming fraudulent expenses from the
company for a significant
period of time.
A new finance director was appointed in January 2015 who was previously
a financial
controller of a bank, and she has expressed surprise that Maple & Co had
not uncovered the fraud
during last year’s audit.
During the year Sycamore has spent $1.8 million on developing several
new products.
Classification: Internal

These projects are at different stages of development and the draft

financial statements show the
full amount of $1.8 million within intangible assets. In order to fund this
development, $2.0
million was borrowed from the bank and is due for repayment over a ten-
year period. The bank
has attached minimum profit targets as part of the loan covenants.
The new finance director has informed the audit partner that since the
year end there has
been an increased number of sales returns and that in the month of May
over $0.5 million of
goods sold in April were returned. Maple & Co attended the year-end
inventory count at
Sycamore’s warehouse. The auditor present raised concerns that during
the count there were
movements of goods in and out the warehouse and this process did not
seem well controlled.
During the year, a review of plant and equipment in the factory was
undertaken and surplus plant
was sold, resulting in a profit on disposal of $210,000.
Describe SIX audit risks, and explain the auditor’s response to each risk, in
planning the
audit of Sycamore Science Co

06. (September 2016)

You are an supervisor of Chania & Co and are planning the audit of your
client, Sitia
Sparkle Co which manufactures cleaning products. Its year end was 31
July 20X6 and the draft

profit before tax is $33.6 million. You are supervising a large audit team
for the first time and
will have specific responsibility for supervising and reviewing the work of
the audit assistants in
your team.
Sitia Sparkle Co purchases most of its raw materials from suppliers in
Africa and these
goods are shipped directly to the company’s warehouse and the goods are
usually in transit for
up to three weeks. The company has incurred $1.3 million of expenditure
on developing a new
range of cleaning products which are due to be launched into the market
place in November
20X6. In September 20X5, Sitia Sparkle Co also invested $0.9 million in a
Classification: Internal

complex piece of
plant and machinery as part of the development process. The full amount
has been capitalised
and this cost includes the purchase price, installation costs and training
costs.
This year, the bonus scheme for senior management and directors has
been changed so that
rather than focusing on profits, it is instead based on the value of year-
end total assets. In previous
years an allowance for receivables, made up of specific balances, which
equalled almost 1% of
trade receivables was maintained. However, the finance director feels that
this is excessive and
unnecessary and has therefore not included it for 20X6 and has credited
the opening balance to
the profit or loss account.
A new general ledger system was introduced in May 20X6; the finance
director has stated that
the data was transferred and the old and new systems were run in parallel
until the end of August
20X6. As a result of the additional workload on the finance team, a
number of control account
reconciliations were not completed as at 31 July 20X6, including the bank
reconciliation. The
finance director is comfortable with this as these reconciliations were
completed successfully for
both June and August 20X6. In addition, the year-end close down of the
purchase ledger was
undertaken on 8 August 20X6.
Required:
Describe SIX audit risks, and explain the auditor’s response to each risk, in
planning the
audit of Sitia Sparkle Co.

07. (June 2014)

Recorder Communications Co (Recorder) is a large mobile phone company
which operates
a network of stores in countries across Europe. The company’s year end is
30 June 2014. You
are the audit senior of Piano & Co. Recorder is a new client and you are
currently planning the
audit with the audit manager. You have been provided with the following
planning notes from
Classification: Internal

the audit partner following his meeting with the finance director.
Recorder purchases goods from a supplier in South Asia and these goods
are shipped to
the Company’s central warehouse. The goods are usually in transit for two
weeks and the
company correctly records the goods when received. Recorder does not
undertake a year end
inventory count, but carries out monthly continuous (perpetual) inventory
counts and any errors
identified are adjusted in the inventory system for that month.
During the year the company introduced a bonus based on sales for its
sales persons. The
bonus target was based on increasing the number of customers signing up
for 24-month phone
line contracts. This has been successful and revenue has increased by
15%, especially in the last
few months of the year. The level of receivables is considerably higher
than last year and there
are concerns about the creditworthiness of some customers. Recorder has
a policy of revaluing
its land and buildings and this year has updated the valuations of all land
and buildings.
During the year the directors have each been paid a significant bonus,
and they have
included this within wages and salaries. Separate disclosure of the bonus
is required by local
legislation.
Required: Describe FIVE audit risks, and explain the auditor’s response to
each risk, in
planning the audit of Recorder Communications Co.
08. (March 2016)
(a) Define audit risk and the components of audit risk.

You are an audit supervisor of Amethyst & Co and are currently planning
the audit of your
client, Aquamarine Co (Aquamarine) which manufactures elevators. Its
year end is 31 July 2016
and the forecast profit before tax is $15.2 million.
The company undertakes continuous production in its factory, therefore at
the year end it
is anticipated that work in progress will be approximately $950,000. In
order to improve the
manufacturing process, Aquamarine placed an order in April for $720,000
Classification: Internal

of new plant and

machinery; one third of this order was received in May with the remainder
expected to be
delivered by the supplier in late July or early August.
At the beginning of the year, Aquamarine purchased a patent for $1.3
million which gives
them the exclusive right to manufacture specialised elevator equipment
for five years. In order to
finance this purchase, Aquamarine borrowed $1.2 million from the bank
which is repayable over
five years.
In January 2016 Aquamarine outsourced its payroll processing to an
external service
organisation, Coral Payrolls Co (Coral). Coral handles all elements of the
payroll cycle and sends
monthly reports to Aquamarine detailing the payroll costs. Aquamarine
ran its own payroll until
31 December 2015, at which point the records were transferred over to
Coral.
The company has a policy of revaluing land and buildings and the finance
director has
announced that all land and buildings will be revalued at the year end.
During a review of the
management accounts for the month of May 2016, you have noticed that
receivables have
increased significantly on the previous year end against May 2015.
The finance director has informed you that the company is planning to
make approximately
65 employees redundant after the year end. No decision has been made
as to when this will be
announced, but it is likely to be prior to the year end.
Required: (b) Describe SIX audit risks, and explain the auditor’s response
to each risk, in
planning the audit of Aquamarine Co.