• Introduction to risk

Topic 2 – Chapter 6
• Materiality
Risk Assessment
• Understanding the entity and its
environment
• Assessing the risks of material
misstatement
• Responding to the risk assessment
• Fraud, law and regulations
• Documentation of risk assessment

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 Syllabus learning outcomes 1

Objectives and general principles

• Identify the overall objectives of the auditor and the need to conduct
an audit in accordance with ISAs.
• Identify the need to plan and perform audits with an attitude of
professional scepticism, and to exercise professional judgement.
Assessing audit risks
• Explain the components of audit risk.
• Explain the audit risks in the financial statements and explain the
auditor's response to each risk.
• Define and explain the concepts of materiality and performance
materiality.
• Explain and calculate materiality levels from financial information.

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 Syllabus learning outcomes 2

Understanding the entity and its environment

• Explain how auditors obtain an initial understanding of the entity and
its environment.
• Describe and explain the nature, and purpose of, analytical
procedures in planning.
• Compute and interpret key ratios used in analytical procedures.

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 Syllabus learning outcomes 3

Fraud, laws and regulations

• Discuss the effect of fraud and misstatements on the audit strategy
and extent of audit work.
• Discuss the responsibilities of internal and external auditors for the
prevention and detection of fraud and error.
• Explain the auditor's responsibility to consider laws and regulations.

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 Overview

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 Chronology of an audit

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 Introduction to risk 1

The overall objective of the external auditor

'To obtain reasonable assurance about whether the financial statements as
a whole are free from material misstatement, whether due to fraud or error,
thereby enabling the auditor to express an opinion on whether the financial
statements are prepared, in all material respects, in accordance with an
applicable financial reporting framework; and to report on the financial
statements, and communicate as required by the ISAs, in accordance with
the auditor's findings.’

(ISA 200 Overall objectives of the auditor and the conduct of an audit in
accordance with International Standards on Auditing, para.11)

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 Introduction to risk 2

Professional scepticism and judgement

In order to achieve the overall objectives of an external audit, the auditor
needs to plan and perform the audit with professional scepticism
and to apply professional judgement (ISA 200, para.13(l)).
➢ Professional scepticism – an attitude that includes a questioning
mind, being alert to conditions which might indicate possible
misstatement due to error or fraud, and a critical assessment of audit
evidence.
• Do pieces of evidence contradict other evidence received?
• Is information received which brings into question the reliability of
audit evidence already obtained?

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 Introduction to risk 3

Professional scepticism and judgement (continued)

➢ Professional judgement – the application of relevant training,
knowledge and experience in making informed decisions about the
courses of action that are appropriate in the circumstance of the audit
engagement (ISA 200, para.13(m)).
The following require professional judgement:
• Determining materiality and audit risk
• Determining nature, timing and extent of audit procedures
• Evaluating whether sufficient appropriate audit evidence has been
obtained
• Drawing conclusions based on the audit evidence obtained
• Evaluating whether management have applied an applicable financial
reporting framework, including management’s judgements

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 Introduction to risk 4

➢ Audit risks: Auditors usually follow a risk-based approach to

auditing as required by IAS.
• In order to obtain assurance that financial statements are free from
material misstatements, the auditor needs to consider how and
where misstatements are most likely to arise.
• The auditor carries out a risk assessment in order to ensure the
areas which are most susceptible to material misstatement are
adequately investigated during the audit.
• We need to understand what risk is in the context of the financial
statements…
• It is therefore very important that you understand the difference
between business risk and audit risk.

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 Introduction to risk 5

Business risk is the risk inherent to the entity in its operations (at all
levels of the business) (see chapter 5).

Audit risk is the risk that the auditor expresses an inappropriate audit
opinion when the financial statements are materially misstated.
ISAs required auditors to follow a risk-based approach.
Audit risk has three components and is illustrated diagramatically on the
next slide.

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 Introduction to risk 6

THE AUDIT RISK MODEL

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

Sampling Risk Non-sampling Risk

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 Introduction to risk 7

• Inherent risk is the susceptibility of an assertion to a misstatement

that could be material individually or when aggregated with other
misstatements, assuming there were no related controls.
• Inherent risk is affected by the nature of the entity; for example, the
industry it is in; the regulations it falls under; and the nature of the
strategies it adopts.
• Examples of factors which could affect inherent risk:
— Integrity of management
— Inventory valuation in a jewellery business
— High cash business such as retail
— Technological obsolescence

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 Introduction to risk 8

• Control risk is the risk that a material misstatement that could occur
in an assertion and that could be material, individually or when
aggregated with other misstatements, will not be prevented or
detected and corrected on timely basis by the entity's internal control.
• Examples:
Monthly bank reconciliations not reviewed by a manager
Purchase invoices not matched to goods received notes
References not followed up for new employees
Computer passwords not required to be changed regularly
• We will look at controls in more detail in Chapters 9 and 10.

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 Introduction to risk 9

• Detection risk is the risk that the procedures performed by the

auditor to reduce audit risk to an acceptably low level will not detect a
misstatement that exists and that could be material, individually or
when aggregated with other misstatements.
• This is the only component of audit risk that the auditors have control
over.
• Notice the difference in emphasis between IR, CR and DR:
• IR and CR relate to the risk of material misstatement being present
in the financial statements.
• DR relates to the risk that the auditor will not detect that
misstatement.

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 Introduction to risk 10

• Detection risk is made up of two components: sampling risk and

non-sampling risk:

Detection risk = Sampling risk + Non-sampling risk

• But simply increasing sample size and carrying out more work are not
the only way to manage detection risk.
• Detection risk is also a function of the effectiveness of an audit
procedure and the way it is applied by an auditor (ie non-sampling
risk).
• The next slide shows examples of sampling risk and non-sampling
risk.
• We look at audit sampling in detail in Chapter 11.

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 Introduction to risk 11

Sampling Risk examples Non-Sampling Risk examples

Sample chosen not representative of Inappropriate audit procedures
population chosen

Misstatement(s) in transactions not Failure to carry out an audit procedure

selected as part of sample correctly

Results wrongly interpreted

Failure to carry out an audit procedure

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 Introduction to risk 12

How can the effectiveness and application of procedures be

improved to help reduce detection risk?
• Adequate planning
• Assignment of more experienced staff to the audit team
• Applying professional scepticism
• Increased supervision and review of audit work

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 Introduction to risk 13

• Control risk and inherent risk together make up the risk of material
misstatement.
• Audit risk must always be set 'to an acceptably low level' – the risk
of the auditor giving the wrong opinion should obviously be as low as
possible.
• Auditors will assess inherent risk and control risk as high, medium or
low.
• Detection risk is the balancing figure in the audit risk equation. So if
inherent risk and control risk are assessed as high, detection risk
must be as low as possible for audit risk to remain low.

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 Introduction to risk 14

RISK OF MATERIAL MISSTATEMENT

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

Sampling Risk Non-sampling Risk

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 Audit Risk

IR

CR

DR

AR

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Relationship among risks

AR CR

High Medium Low

High Lowest Low Medium

IR Medium Low Medium High

Low Medium High Highest

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 Materiality 1

What is materiality and why does it matter?

The objective of an external audit of financial statements is to enable
the auditor to express an opinion on whether the financial statements
are prepared, in all material respects, in accordance with an
applicable financial reporting framework.
• The external auditor cannot test every transaction and balance
that make up the financial statements – this would simply not be
feasible or cost-effective. Hence, the concept of materiality is
suggested.
• Materiality is an expression of the relative significance or importance
of a particular matter in the context of the financial statements as a
whole.

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 Materiality 2

When is materiality made?

• Materiality is calculated for the financial statements as a whole and
Performance materiality must be calculated at planning stage,
based on experience and judgement.
• Misstatements are considered to be material if they, individually or in
aggregate, could reasonably be expected to influence the economic
decisions of users.
• Judgements about materiality are made in the light of surrounding
circumstances and are affected by the size and nature of a
misstatement or a combination of both.
• Judgements about matters that are material to users of financial
statements are based on a consideration of the common financial
information needs of users as a group.
(ISA 320 Materiality in planning and performing an audit)

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 Materiality 3

How is materiality calculated?

• Materiality is a matter of judgement and depends on audit risk.
• The higher the audit risk, the lower the value of materiality.
• Materiality is calculated for the financial statements as a whole.
• Performance materiality is calculated for particular classes of
transactions, balances and disclosures.
• Materiality must be reviewed throughout the audit and revised if
necessary.

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 Materiality 4

Materiality for the financial statements as a whole

Benchmark %
Profit before tax 5
Gross profit 0.5 – 1
Revenue 0.5 – 1
Profit after tax 5 – 10
Total assets 1–2
Net assets 2–5

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 Materiality 5

Performance materiality
• The auditor is required to set performance materiality as well as
Overall Materiality (OM) for the financial statements as a whole.
• Performance Materiality (PM) is the amount(s) set by the auditor at
less than materiality for the financial statements as a whole to reduce
to an appropriately low level the probability that the aggregate of
uncorrected and undetected misstatements exceeds materiality for
the financial statements as a whole.
• Performance materiality also refers to the amount or amounts set by
the auditor at less than the materiality level(s) for particular classes of
transactions, account balances or disclosures.

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 Materiality 6

➢ Revision of materiality: Level of materiality should be revised for the financial statements
as a whole if during the audit it appears that actual results are going to be significant
different from expected results, which are used to calculate materiality for the financial
statements as a whole during planning (ISA 320: para. A 12)
➢ Documentation of materiality, IAS requires the following to be document:
• Materiality for the financial statements as a whole
• Materiality level of levels for particular classes of transactions, account balance or
disclosure if applicable
• Performance materiality
• Any revision of the above as the audit progress
(ISA 320: para. 14)

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 Tackling the exam

• Questions on materiality could be knowledge-based or

application-based and come up either in section A or section B.
• Materiality can also be tested in a question on auditor's reports
where you could be presented with various scenarios and asked
to comment on possible impacts on the auditor's report.
• In such questions, if you are given figures for revenue/profit before
tax/net assets etc, make sure you calculate a figure for materiality
and use it in your answer!
• We will look at these sorts of questions in more detail when we
come to Chapter 19.

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 Question: Specimen exam (Sec A, question 10)

During the planning stages of the final audit, the auditor believes that the probability of giving
an inappropriate audit opinion is too high.
How should the auditor amend the audit plan to resolve this issue?
A Increase the materiality level
B Decrease the inherent risk
C Decrease the detection risk

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 Question: Specimen exam (Sec A, question 10) cont'd

C Decrease the detection risk

Increasing the materiality level would mean that the auditor considered the audit to be of a
lower risk. Inherent risk cannot be controlled by the auditor. The only element of audit risk
that is within the auditor's control is detection risk, so if there is a high risk of giving an
inappropriate audit opinion, the auditor needs to ensure that detection risk is as low as
possible.

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• Understanding
the entity and
its environment

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 Understanding the entity and its environment 1

• We have talked about the importance of risk. But how do we identify

what the risks are?
• By understanding the entity and its environment.
ISA 315 Identifying and assessing the risks of material misstatement
through understanding the entity and its environment

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 Understanding the entity and its environment 2

Why does an auditor need to understand the entity and its

environment?
• To identify and assess the risks of material misstatement in the
financial statements
• To enable the auditor to design and perform further audit procedures
• To provide a frame of reference for exercising audit judgement, eg
when setting audit materiality
(ISA 315 (revised): para. A1)

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 Understanding the entity and its environment 3

What does an auditor need to understand about the entity and its
environment?
• Industry, regulatory and external factors (including financial reporting
framework)
• Nature of the entity (eg operations; ownership; governance; structure;
financing)
• Selection and application of accounting policies
• Objectives and strategies and related business risks
• Measurement and review of financial performance
• Internal control
(ISA 315 (revised): paras.11-12)

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 Understanding the entity and its environment 4

How does an auditor understand the entity and its environment?

• Inquiries of management, internal auditors and others
• Analytical procedures (these must be used at risk assessment!)
• Observation and inspection
• Prior period knowledge
• Client acceptance or continuance policies
• Discussion by audit team
• Information from other engagements undertaken for the entity
Understanding the entity and its environment -10)

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 Understanding the entity and its environment 5

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 Understanding the entity and its environment 6

➢ How do the auditors gain an understanding?

• Enquires of management, internal auditors and other within the entity
• Analytical procedure
• Observation and inspection
(ISA 315 (revised): para. 6)

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➢ Analytical procedures consist of
evaluations of financial information
through analysis of plausible
relationship among both financial and
non-financial data. Analytical procedures
also encompass investigation of
identified fluctuations or relationships
that are inconsistent with other relevant
information or that differ from expected
values by a significant amount.

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Analytical procedures include:
(a) The consideration of comparisons with:
• Similar information for prior periods
• Anticipated results of the entity, from budgets or forecasts
• Predictions prepared by the auditors
• Industry information
(b) The consideration of the relationship between elements of financial information that are
expected to conform to a predicted pattern based on the entity's experience, such as the
relationship of gross profit to sales.
(c) The consideration of the relationship between financial information and relevant non-financial
information, such as the relationship of payroll costs to number of employees.

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 Exam link

Have a look at this useful article from the January 2013 edition of
Student Accountant, which covers ISA 315:
[Link]
students/2012s/sa_jan13_fau_f8_p7_isa315.pdf

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• Assessing the risks of
material misstatement

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 Assessing the risks of material misstatement 1

• Having obtained an understanding of the entity, an auditor must

identify and assess the risks of material misstatement in the
financial statements.
• To do this the auditor should:
— Identify risks throughout the process of obtaining an
understanding of the entity and its environment
— Assess the identified risks and evaluate whether they relate more
pervasively to the financial statements as a whole
— Relate the risks to what can go wrong at the assertion level (see
Chapter 8)
— Consider the likelihood of the risks causing a material
misstatement

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 Assessing the risks of material misstatement 2

• The auditor must also consider significant risks, ie those that require
special consideration.
• Factors that give risk to significant risks include:
— The risk of fraud
— Relationship with economic, accounting or other developments
— Degree of subjectivity
— Unusual transaction
— Significant transaction with a related party
— Complexity of transaction

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 Responding to the risk assessment 1

• ISA 330 The auditor's responses to assessed risks

• The auditor needs to obtain sufficient audit evidence regarding the
assessed risks.
• Overall responses include emphasising to the audit team the
importance of professional scepticism, allocating more staff, using
experts or providing more supervision.
• Responses to the risks of material misstatement at the assertion
level include tests of controls and substantive procedures.
• The following article on ISA 330 from the April 2010 edition of Student
Accountant may prove useful:
[Link]
students/2012s/sa_apr10_f8.pdf

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 Responding to the risk assessment 2

• Tests of controls are audit procedures designed to evaluate the

operating effectiveness of controls in preventing, or detecting and
correcting, material misstatements at the assertion level.
• When carrying out tests of control, an auditor will often use inquiry.
Re-performance and inspection can often also be helpful
procedures.
• We will look at tests of controls in more detail in Chapters 9 and 10.

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 Responding to the risk assessment 3

• Substantive procedures are audit procedures designed to detect

material misstatements at the assertion level.
• They are of two types: tests of detail and substantive analytical
procedures.
• Substantive procedures must always be carried out on material
items.
• Some degree of substantive testing will always have to be carried out.

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 Responding to the risk assessment 4

• Tests of details may be appropriate to gain information about

account balances, eg inventory, non-current assets.
• Substantive analytical procedures are appropriate for large
volumes of predictable transactions, eg wages and salaries.
• Tests of detail (rather than analytical procedures) are likely to be
more appropriate in relation to matters which have been identified as
significant risks.

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 Tackling the exam 1

• Audit risk is a key syllabus area and you are very likely to get a
question on risk in the exam.
• This could be tested either as knowledge-based or scenario-
based requirements so could appear in both section A and section
B (either in a 10-mark or a 20-mark question).
• It is very important that you understand what audit risk is and can
distinguish it from business risk.
• This area of the syllabus is best tackled by practising as many
past exam questions as possible.
• Have a look at this article published by the F8 examiner in
November 2011:
[Link]
journey/qual-resource/acca-qualification/f8/technical-articles/audit-
[Link]

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 Tackling the exam 2

• Audit risk questions may present you with a scenario and ask you
to identify the audit risks and explain the auditor's responses to
those risks.
• This type of requirement has come up in June 2011, December
2011, December 2012 and June 2013 (all worth 10 marks) under
the old syllabus. A similar question appears in the Specimen
Paper (section B, question 5a), worth 15 marks.
• For these type of questions, use a columnar format, headed 'Audit
risks' and 'Auditor's responses'.

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 Tackling the exam 3

• Make sure you explain fully the risk to the financial statements –
you won't get full marks for simply writing down the risk factor (eg
'inventory')
• What financial statement risks might arise from inventory? (eg risk
that net realisable value of inventory is lower than cost and
therefore inventory figure is overstated)
• The auditor's responses need to be specific. Writing down things
like 'Discuss with management' is vague – you need to explain
what exactly the auditor needs need to discuss with management.
• Suitable responses to each risk may also depend on the particular
circumstances of the client and the environment in which it
operates. Make sure you tailor any responses you recommend so
that they are appropriate to the scenario.

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 Tackling the exam 4

• If an exam question presents you with a scenario and asks you to

describe or explain the audit risks, you do not have to define audit
risk and its components.
• You will not get any marks for doing so if this was not required by
the question. Including superfluous material in your answer will not
gain you any credit and will waste valuable time in a very
time-pressured paper.

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 Question: Specimen exam (Sec B, question 5a)

You are the audit senior of Holtby & Co and are planning the audit of Walters Co (Walters) for
the year ended 31 December 20X4. The company produces printers and has been a client of
your firm for two years; your audit manager has already had a planning meeting with the
finance director. He has provided you with the following notes of his meeting and financial
statement extracts.
Walter's management were disappointed with the 20X3 results and so in 20X4 undertook a
number of strategies to improve the trading results. This included the introduction of a
generous sales-related bonus scheme for their salesmen and a high profile advertising
campaign. In addition, as market conditions are difficult for their customers, they have
extended the credit period given to them.

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 Question: Specimen exam (Sec B, question 5a) cont'd

The finance director of Walters has reviewed the inventory valuation policy and has included
additional overheads incurred this year as he considers them to be production related.
The finance director has calculated a few key ratios for Walters; the gross profit margin has
increased from 44.4% to 52.2% and receivables days have increased from 61 days to 71
days. He is happy with the 20X4 results and feels that they are a good reflection of the
improved trading levels.

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 Question: Specimen exam (Sec B, question 5a) cont'd

Financial statement extracts for the year ended 31 December

DRAFT ACTUAL
20X4 20X3
$m $m
Revenue 23.0 18.0
Cost of sales (11.0) (10.0)
Gross profit 12.0 8.0
Operating expenses (7.5) (4.0)
Profit before interest and taxation 4.5 4.0

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 Question: Specimen exam (Sec B, question 5a) cont'd

Financial statement extracts for the year ended 31 December

DRAFT ACTUAL
20X4 20X3
$m $m
Inventory 2.1 1.6
Receivables 4.5 3.0
Cash - 2.3
Trade payables 1.6 1.2
Overdraft 0.9 -

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 Question: Specimen exam (Sec B, question 5a) cont'd

Required:
(a) Using the information above:
(i) Calculate an additional THREE ratios, for BOTH years, which
would assist the audit senior in planning the audit; and
(3 marks)
(ii) From a review of the above information and the ratios
calculated, describe SIX audit risks and explain the auditor's
response to each risk in planning the audit of Walters Co.
(12 marks)

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 Approach: Specimen exam (Sec B, question 5a)

• Notice the specific requirements in each part – in (i), you need to calculate an additional
three ratios for both years. Therefore, make sure you do this and remember the ratios you
have already been given in the scenario.
• In (ii), you need to describe six audit risks and the auditor's responses in each case.
Students often misinterpret the part about auditor's responses and instead provide
additional explanation of the risk.
• Part (ii) would be best answered in a columnar format so the risk and response can be
linked.
• Go through the scenario line-by-line and note down the risk areas.
• Use the ratios calculated in (i) to support your answer in (ii).
• Remember not to confuse audit risk and business risk!

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 Answer: Specimen exam (Sec B, question 5a)(i))

Ratio 20X4 20X3

Operating margin 4.5/23 x 100 = 19.6% 4/18 x 100 = 22.2%
(profit/revenue x 100%)
Inventory days 2.1/11 x 365 = 70 days 1.6/10 x 365 = 58 days
(inventory/cost of sales
x 365)
Payables days 1.6/11 x 365 = 53 days 1.2/10 x 365 = 44 days
(payables/cost of sales
x 365)
Current ratio 6.6/2.5 = 2.6 6.9/1.2 = 5.8
Quick ratio (6.6 – 2.1)/2.5 = 1.8 (6.9 – 1.6)/1.2 = 4.4

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 Answer: Specimen exam (Sec B, question 5a)(ii))

Audit risk Auditor's response

The company has offered a generous sales-related The auditors will need to increase cut-off testing
bonus scheme for its salesmen. This increases the around the year end to ensure revenue has been
risk of revenue misstatement so that employees included in the correct period.
aim to maximise their bonus.

The increase in cost of sales (10%) does not match The auditors will need to focus on sales testing
the increase in revenue (28%) in the year. This and the testing of expenses. They should also
gives rise to the risk that revenue has been discuss the reason for the disproportionate
overstated and cost of sales has been increase in the gross margin with the finance
understated. director.
The finance director has included some additional The inventory policy needs to be discussed with
overheads in inventory. Inventory days have the finance director. The auditors should examine
increased from 58 days to 70 days. Inventory may the nature of the additional overheads included
therefore be overstated and expenses in inventory to confirm whether their inclusion is
understated. correct. Detailed cost and NRV testing should be
performed and the aged inventory listing
reviewed to assess the need for write-down.

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 Answer: Specimen exam (Sec B, question 5a(ii)) cont'd

Audit risk Auditor's response

Gross margin has increased from the previous year from The auditors should obtain a detailed breakdown of the
44.4% to 52.2%, whereas operating margin has gone costs included in cost of sales and operating expenses to
down from 22.2% to 19.6%. There is a risk that costs establish whether there has been incorrect allocation
have been misclassified between cost of sales and between the two.
operating expenses.

Receivables days have increased from 61 days to 71 The auditors should carry out detailed substantive testing
days. This means customers are taking longer to pay the on year end receivables, including monitoring post year
company. This gives rise to the risk of receivables end receipts and review of the aged receivables ledger
being overstated if some customers are be unable to to assess recoverability.
pay.

The company now has a significant overdraft. This, The auditors should discuss whether the company can
together with the worsening liquidity position (shown by continue as a going concern with the directors and also
the current and quick ratios), gives rise to the going carry out a detailed going concern review, including
concern risks. review of forecasts and budgets.

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 Question: June 2011 question 3b

Donald Co operates an airline business. The company's year end is

31 July 20X1.
You are the audit senior and you have started planning the audit.
Your manager has asked you to have a meeting with the client and to
identify any relevant audit risks so that the audit plan can be
completed. From your meeting you ascertain the following:
In order to expand their flight network, Donald Co will need to acquire
more airplanes; they have placed orders for another six planes at an
estimated total cost of $20m and the company is not sure whether
these planes will be received by the year end. In addition the
company has spent an estimated $15m on refurbishing their existing
planes. In order to fund the expansion Donald Co has applied for a
loan of $25m. It has yet to hear from the bank as to whether it will
lend them the money.

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 Question: June 2011 question 3b (cont'd)

The company receives bookings from travel agents as well as directly

via their website. The travel agents are given a 90-day credit period
to pay Donald Co. However, due to difficult trading conditions a
number of the receivables are struggling to pay. The company's
website was launched in 20X0 and has consistently encountered
difficulties with customer complaints that tickets have been booked
and paid for online but Donald Co has no record of them and hence
has sold the seat to another customer.
Donald Co used to sell tickets via a large call centre located near to
their head office. However, in May 20X1 they closed it down and
made the large workforce redundant.

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 Question: June 2011 question 3b (cont'd)

Required:
Using the information provided, describe FIVE audit risks and explain
the auditor's response to each risk in planning the audit of Donald
Co. (10 marks)

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 Approach: June 2011 question 3b

• Firstly notice the requirement for FIVE audit risks and responses.
Make sure you provide five in your answer.
• You need to describe the audit risks and explain the auditor's
responses.
• Assume one mark for each risk and one mark for each response.
• Go through the scenario line-by-line to pull out the areas of
potential audit risk. This has been done for you in the next two
slides in colour.
• Use a columnar format for your answer (with the risks in one
column and the responses to that risk in the other column).
• Use a ruler for the table and headings to improve your
presentation.

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 Approach: June 2011 question 3b (cont'd)

Donald Co operates an airline business. The company's year end is

31 July 20X1.
You are the audit senior and you have started planning the audit.
Your manager has asked you to have a meeting with the client and to
identify any relevant audit risks so that the audit plan can be
completed. From your meeting you ascertain the following:
In order to expand their flight network, Donald Co will need to acquire
more airplanes; they have placed orders for another six planes at an
estimated total cost of $20m and the company is not sure whether
these planes will be received by the year end. In addition the
company has spent an estimated $15m on refurbishing their existing
planes. In order to fund the expansion Donald Co has applied for a
loan of $25m. It has yet to hear from the bank as to whether it will
lend them the money.

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 Approach: June 2011 question 3b (cont'd)

The company receives bookings from travel agents as well as directly

via their website. The travel agents are given a 90-day credit period
to pay Donald Co. However, due to difficult trading conditions a
number of the receivables are struggling to pay. The company's
website was launched in 20X0 and has consistently encountered
difficulties with customer complaints that tickets have been booked
and paid for online but Donald Co has no record of them and hence
has sold the seat to another customer.
Donald Co used to sell tickets via a large call centre located near to
their head office. However, in May 20X1 they closed it down and
made the large workforce redundant.

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 Answer: June 2011 question 3b
Audit risk Auditor's response
The company has spent $15m on Increased substantive testing in this area.
refurbishing existing planes. This is likely Obtain a schedule of a breakdown of the
to be a material amount and there is a risk $15m and select a sample for testing to
that costs have been incorrectly allocated ensure correct accounting treatment of
between revenue and capital. costs between capital and revenue.

The company has applied for a bank loan Discuss the progress of the loan
of $25m to fund the purchase of new application with directors.
planes and refurbishment costs. There is Perform a going concern review, looking
a risk that the company cannot continue at cash flow forecasts and projections for
as a going concern if the loan is not the next year.
approved.
There is a risk of the receivables balance Increased substantive testing using
in the financial statements being receivables' confirmation and review of
misstated as some balances due from after-date cash. Discuss with directors the
travel agents may not be recoverable. requirement for an allowance for
irrecoverable debts.

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 Answer: June 2011 question 3b (cont'd)

Audit risk Auditor's response

The new website has encountered Obtain a schedule of tickets double-
problems leading to customer booked and for a sample, follow through
dissatisfaction as seats have been to ensure refunds were awarded and
double-booked. There is a risk of the revenue has been corrected.
company having to refund customers and
therefore overstating revenue.
The closure of the call centre in May has Discuss the level of the provision required
already been announced and so a with management. Review the
provision for redundancy will be required. calculations for the provision for
reasonableness. Review draft accounts to
ensure correct disclosures relating to the
closure of the call centre.

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 Fraud, law and regulations 1

Fraud
Fraud is an intentional act by one or more individuals among
management, those charged with governance, employees or third parties
involving the use of deception to obtain an unjust or illegal
advantage. Fraud may be perpetrated by an individual, or colluded in,
with people internal or external to the business.
Fraud risk factors are events or conditions which indicate an incentive
or pressure to commit fraud, or provide an opportunity to commit fraud.
There are two types of fraud:
1. Fraudulent financial reporting
2. Misappropriation of assets

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 Fraud, law and regulations 2

Fraudulent financial reporting

Involves intentional misstatements, including omissions of amounts or
disclosures in financial statements, to deceive users of the financial
statements.

Examples
• Manipulation, falsification or alteration of accounting records and/or
supporting documents
• Misrepresentation (or omission) of events or transactions in the
financial statements
• Intentional misapplication of accounting principles

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 Fraud, law and regulations 3

Misappropriation of assets
Involves the theft of an entity's assets and is often perpetrated by
employees in relatively small and immaterial amounts. However, it can
also involve management who are usually more capable of disguising or
concealing misappropriations in ways that are difficult to detect.

Examples
• Embezzling receipts (for example, diverting them to private bank
accounts)
• Stealing physical assets or intellectual property (inventory, selling
data)
• Causing an entity to pay for goods not received (payments to fictitious
vendors)
• Using assets for personal use
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 Real World Example: Saytam Computer Services

In 2009, the Chairman of Saytam Computer Services (in India),

Ramalinga Raju, admitted to falsifying the financial statements of the
company by almost $1.5 billion.
The financial statements contained falsified revenues, margins and
cash balances, resulting in over-inflated revenue figures.
The Chairman admitted the fraud in a letter to the Board of Directors
of the company.
Here is an extract from his letter:

"What started as a marginal gap between actual operating profit and

the one reflected in the books continued to grow over the years. It
has attained unmanageable proportions as the size of the company's
operations grew over the years."

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 Fraud, law and regulations 4

Prevention and detection of fraud

The primary responsibility for the prevention and detection of fraud rests
those changed with governance and management. It is not primarily the
responsibility of the external auditor!
However, as part of their risk assessment, auditors should discuss how
and where the financial statements may be susceptible to fraud.
ISA 240 The auditor's responsibilities relating to fraud in an audit of
financial statements

So what are the responsibilities of the auditor?

The auditor is responsible for obtaining reasonable assurance that the
financial statements are free from material misstatement, whether
caused by fraud or error.

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 Fraud, law and regulations 5

However, the risk of not detecting a material misstatement from fraud is

higher than from error because:
• Fraud may involve sophisticated schemes designed to conceal it.
• Fraud may be perpetrated by individuals in collusion.
• Management fraud is harder to detect because management is in a
position to manipulate accounting records or override control
procedures.
Professional scepticism is important here – eg the auditor should
consider the possibility of management overriding controls.

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 Fraud, law and regulations 6

Written representations
ISA 240 requires the auditor to obtain written representations from
management and those charged with governance that:
• They acknowledge their responsibility for the design, implementation
and maintenance of internal control to prevent and detect fraud.
• They have disclosed to the auditor management's assessment of
the risk of fraud in the financial statements.
• They have disclosed to the auditor their knowledge of any fraud or
suspected fraud which could have a material effect on the financial
statements.
• They have disclosed to the auditor their knowledge of any
allegations of fraud or suspected fraud communicated to
employees, former employees, analysts, regulators or others.

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 Fraud, law and regulations 7

ISA 250 Consideration of laws and regulations in an audit of financial

statements.

Management's responsibility
To ensure that the entity complies with the relevant laws and regulations.
It is not the auditor's responsibility to prevent or detect non-compliance
with laws and regulations.

Auditor's responsibility
To obtain reasonable assurance that the financial statements are free
from material misstatement.
However, auditor must also take into account the legal and regulatory
framework within which the entity operates.

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 Fraud, law and regulations 8

• ISA 315 requires auditors to obtain a general understanding of the

applicable legal and general framework and how the entity complies
with it.
• For example, making inquiries of management about laws and
regulations that may affect the entity, and about the entity's policies
and procedures or ensuring its complies with relevant legislation.
• The auditor shall remain alert to the possibility that audit procedures
may highlight instances of non-compliance.
• Any non-compliance should be reported to those charged with
governance or the audit committee, if the auditor suspects that those
charged with governance are involved.

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 Exam link: ISA 240 and ISA 250

• ISA 240 and ISA 250 are more likely to be tested as a short
requirement worth three or four marks in section B.
• The examiner wants to test your understanding of the respective
responsibilities of management and the external auditor in relation
to fraud and in relation to compliance with laws and regulations.
• The F8 examiner has tested these elements of the syllabus in
previous sittings (December 2011 (question 1c), June 2012
(question 3a) and June 2013 (question 4b)).

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 Documentation of risk assessment 1

• Auditors must document the work they have done at the risk
assessment stage.
• We will look at documentation in greater detail in Chapter 7 when we
discuss the audit strategy and the audit plan.
• But there are a number of matters which need to be documented
during the risk assessment and planning stages of an audit…

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 Documentation of risk assessment 2

What needs to be documented?

• The discussion among the audit team concerning the susceptibility of
the financial statements to material misstatements, including any
significant decisions reached
• Key elements of the understanding gained of the entity regarding the
elements of the entity and its internal control components, sources of
information gained and the risk assessment procedures undertaken
• The identified and assessed risks of material misstatement at the
financial statement level and assertion level
• Risks identified and related controls evaluated
• Overall responses to address the risks of material misstatement at the
financial statement level

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 Documentation of risk assessment 3

What needs to be documented? (continued)

• Nature, extent and timing of further audit procedures linked to the
assessed risks at the assertion level
• Results of audit procedures
• If the auditors have relied on evidence about the effectiveness of
controls from previous audits, conclusions about how this is
appropriate
• Demonstration that the financial statements agree or reconcile with
the underlying accounting records

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