7/25/2019 Review for Midterms

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Candidates studying Paper F8, Audit and Assurance, are required under the syllabus to: ‘Explain

the components of audit risk and explain the risks of material misstatement in the financial

statements!"his element of the syllabus has been examined in the last three sessions of Paper F8 # in $une

%&'&, (ecember %&'& and $une %&''! )o*e+er, the performance of candidates has on the *hole

 been unsatisfactory! "his article aims to identify the most common mistakes made by candidatesas *ell as clarifying ho* audit risk questions should be tackled in order to maximise marks!

n example question requirement relating to audit risks is as follo*s:

 Describe the audit risks and explain the auditor’s response to each risk in planning the audit of

 XYZ Co.

Pre+iously examined risk questions ha+e carried a mark allocation of '& marks! )o*e+er, asignificant ma-ority of candidates ha+e not passed this part of the question! Common mistakes

made include:

•  pro+iding definitions of the audit risk model, e+en though this *as not part of the

question requirement

• a lack of understanding of *hat audit risk is and pro+iding business risks instead

• not pro+iding an adequate response to the risk! "his needs to be from the perspecti+e of

the auditor and not from managements perspecti+e

• a limited range of risks identified, often -ust focusing on one area such as going concern!

AUDIT RISK DEFINITIONS

udit risk is defined as ‘the risk that the auditor expresses an inappropriate audit opinion *henthe financial statements are materially misstated! udit risk is a function of the risks of material

misstatement and detection risk! )ence, audit risk is made up of t*o components # risks of

material misstatement and detection risk!.isk of material misstatement is defined as ‘the risk that the financial statements are materiallymisstated prior to audit! "his consists of t*o components!!! inherent risk !!! control risk!

/nherent risk is ‘the susceptibility of an assertion about a class of transaction, account balance or

disclosure to a misstatement that could be material, either indi+idually or *hen aggregated *ith

other misstatements, before consideration of any related controls!

Control risk is ‘the risk that a misstatement that could occur in an assertion about a class oftransaction, account balance or disclosure and that could be material, either indi+idually or *hen

aggregated *ith other misstatements, *ill not be pre+ented, or detected and corrected, on a

timely basis by the entitys internal control!

(etection risk is defined as ‘the risk that the procedures performed by the auditor to reduce auditrisk to an acceptably lo* le+el *ill not detect a misstatement that exists and that could be

material, either indi+idually or *hen aggregated *ith other misstatements!

udit risk questions require candidates to identify risks of material misstatements, *hich include

inherent and control risks as *ell as detection risks!

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AUDIT RISK MODEL

/n all three sessions a number of candidates ha+e *asted +aluable time by describing the auditrisk model along *ith definitions of audit risk, inherent risk, control and detection risk! 0nless

the question requirement specifically asks for the ‘components of audit risk or ‘a description of

the audit risk model, candidates should not pro+ide definitions of audit risk, inherent risk,control risk or detection risk as no marks are a+ailable!

AUDIT RISK VERSUS BUSINESS RISK 

"he main area *here candidates continue to lose marks is that they do not actually understand*hat audit risk relates to! )ence, they frequently pro+ide ans*ers that consider the risks the

 business *ould face or ‘business risks, *hich are outside the scope of the syllabus! "here are no

marks a+ailable for business risks!

1usiness risks are defined as ‘a risk resulting from significant conditions, e+ents, circumstances,actions or inactions that could ad+ersely affect an entitys ability to achie+e its ob-ecti+es and

execute its strategies, or from the setting of inappropriate ob-ecti+es and strategies!.isks must be related to the risk arising in the audit of the financial statements and should

include the financial statement assertion impacted! "herefore, audit risks should be related back

to rele+ant assertions!

/2 3'4, Identifying and Assessing the Risks of aterial isstate!ent "hrough #nderstandingthe $ntity and Its $n%iron!ent identifies the follo*ing assertions:

• ssertions about classes of transactions and e+ents for the period under audit #

occurrence completeness, accuracy, cut off and classification!

• ssertions about account balances at the period end # existence, rights and obligations

completeness, and +aluation and allocation!

• ssertions about presentation and disclosure # occurrence and rights and obligations,

completeness, classification and understandability, and accuracy and +aluation!

/n addition, a risk can relate to a practical problem the audit team may face, such as attendance at

in+entory counts *here the company has multiple sites holding simultaneous in+entory counts,

or if the company has had significant changes in their finance department and so the risk of fraudand error has increased!

"he common mistake is for candidates to identify a rele+ant issue from the scenario and then

consider the risk to the company rather than to the auditor, linking into the related assertion!

"herefore, using 5uestion 3b from the $une %&'' exam: ‘"he tra+el agents are gi+en a 6&7daycredit period to pay (onald Co ho*e+er, due to difficult trading conditions, a number of therecei+ables are struggling to pay! "he audit risk related to this point is that if recei+ables are

struggling to pay, then they may be o+erstated and, hence, +aluation of recei+ables is the rele+ant

risk!

"he business faces the risk of slo* cash flo*s and so there is a business risk related to the

liquidity of (onald Co! 9hile going concern is an audit risk, the abo+e point from the scenario isnot sufficient on its o*n to indicate going concern risk!

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/n addition, 5uestion 'a from the $une %&'& exam told candidates: ‘Purchase orders for o+erseas

 paint are made six months in ad+ance and goods can be in transit for up to t*o months! "he

explanation of the audit risk *ould be to ascertain that the cut7off of in+entory is appropriate atthe year end! )o*e+er, many candidates explained that the company may encounter problems

*ith stock7outs of goods, *hich is focused more on operational business risk rather than on the

risks to the financial statements!ther examples of audit risks include:

• treatment of capital and re+enue expenditure # the risk here could relate to existence of

 property plant and equipment if re+enue expenditure has been capitalised rather than

charged as an expense in the income statement

• +aluation of in+entory # *hen, for example, there are considerable le+els of aged

in+entory

• completeness of liabilities # this could arise if pro+isions ha+e been incorrectly treated as

contingent liabilities

•completeness of re+enue # this could be rele+ant *here the entity being audited has

significant cash sales!

RESPONSES TO AUDIT RISKS

)a+ing identified the audit risk candidates are often required to identify the rele+ant response to

these risks! common mistake made by candidates is to pro+ide a response that management

*ould adopt rather than the auditor!

From 5uestion 3b $une %&'', in relation to the risk of +aluation of recei+ables, as (onald Co hada number of recei+ables *ho *ere struggling to pay, many candidates suggested that

management needed to chase these outstanding customers! "his is not a response that the auditor

*ould adopt, as they *ould be focused on testing +aluation through after date cash receipts orre+ie*ing the aged recei+ables ledger!

uditors responses should focus on ho* the team *ill obtain e+idence to reduce the risks

identified to an acceptable le+el! "heir ob-ecti+e is confirming *hether the financial statement

assertions ha+e been adhered to, and *hether the financial statements are true and fair!

.esponses are not as detailed as audit procedures instead they relate to the approach the auditor*ill adopt to confirm *hether the transactions or balances are materially misstated! "herefore, in

relation to the risk of going concern, the response is to focus on performing additional going

concern procedures, such as re+ie*s of cash flo* forecasts!

lso, auditor responses should not be too +ague such as ‘increase substanti+e testing *ithout

making it clear ho*, or in *hat area, this *ould be addressed!

/n addition, candidates must ensure that they do not pro+ide impractical responses! common

example of this is to request directly from the companys bank as to *hether the bank *ill

 pro+ide a loan or rene* a bank o+erdraft! "he bank is not going to pro+ide this type ofinformation to the auditor, especially if they ha+e not yet informed the company, and therefore

this response *ill not generate any marks!

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LIMITED RANGE OF RISKS IDENTIFIED

/n order to score *ell in risk questions it is ad+isable to aim to identify a breadth of points fromthe question scenario! /f the question asks for a specific number of audit risks, such as fi+e, then

it is not sufficient to identify -ust one or t*o risks! /n addition, a common mistake is to identify a

risk such as going concern and then gi+e this ans*er o+er and o+er again! /n 5uestion 3b of the$une %&'' exam, there *as only a maximum of one mark a+ailable for the description of going

concern risk!

Each scenario *ill ha+e a +ariety of audit risks and candidates should, as part of their planning,

aim to identify as many as possible! "hey should then decide *hich of the identified risks they*ill explain;describe in their ans*er! /f the question asks for fi+e risks, candidates should aim to

identify six or se+en points during their initial reading of the question! Candidates should then

re+ie* their list and pick the fi+e risks and responses that they feel they can expand on the most*hen *riting up their ans*er!

CONCLUSIONudit risk is, and *ill continue to be, an important element of the Paper F8 syllabus! Candidates

must understand the syllabus outcomes, understand *hat the question requirements in+ol+e and practise risk questions prior to the exam!

Written by a member o t!e Pa"er F# e$aminin% team