ACCA AA
Chapter 5
Audit risk
READ TECHNICAL ARTICLE : AUDIT RISK & ANALYTICAL PROCEDURE
Risk of material misstatement
Risk of material misstatement is the risk that the financial statements are materially misstated
prior to the audit.
Objective of auditor
At the planning stage of the audit, the auditor assess risky areas in the financial statements, where
the attention needs to be given when the audit commences through Understanding the Entity and
Its Environment. The approach adopted by the auditor to assess risky areas within the financial
statements is known as audit risk approach
'The objective of the auditor is to identify and assess the risk of material misstatement, whether
due to fraud or error, at the financial statement and assertion levels, thereby providing a basis for
designing and implementing responses (audit procedures) to the assessed risks of material
misstatement.'- ISA 330 The Auditor's Responses to Assessed Risks
ISA 315 (Revised) Identifying and Assessing the Risks of Material Misstatement through
Understanding the Entity and Its Environment requires auditors to perform the following
(minimum) risk assessment procedures:
• Enquiries with management
• Analytical procedures to identify trends/relationships that are inconsistent with other
relevant information or the auditor's understanding of the business.
• Observation
• Inspection
Audit Risk
Audit risk is the risk that the auditor expresses an inappropriate opinion when the
financial statements are materially misstated.
Audit risk= Risk of material misstatement (ROMM) x Detection risk
Audit risk is a function of two risks:
➢ The risk that the draft financial statements actually contain a material misstatement
before the audit. This is the risk of material misstatement ('ROMM')
➢ The risk that audit procedures fail to detect it, so that the financial statements are
published with the misstatement still present. This is detection risk.
Lecture notes by Kevin Binoy
ACCA AA
ROMM has two components
➢ Inherent Risk: Originates from the nature of the entity and its environment, without
considering any internal controls.
➢ Control Risk: Arises from the possibility that the internal controls fail to prevent or
detect material misstatements.
Audit risk = inherent risk x control risk x detection risk
Detection risk comprises sampling risk and non-sampling risk:
➢ Sampling risk – is the risk that the sample size was or the material misstatement was not
captured in the sample ( i.e. the sample was clean)
➢ Non-sampling risk – there might be situations in audit where the issue is not with sample
rather the issue is something else leading to auditor failure for e.g.
• Junior auditor was engage to perform risky areas of the financial statements
• Manager was busy or was not well and he didn’t had chance to supervise or review
the audit engagement
The auditor must amend the audit approach in response to risk assessment to ensure they detect the
material misstatements in the financial statements.
Professional scepticism
Professional scepticism is: 'An attitude that includes a questioning mind, being alert to conditions
which may indicate possible misstatement due to fraud or error, and a critical assessment of audit
evidence.'
Exam approach on Audit risk
Risk in relation with an Accounting standard
✓ Identify risk
✓ Accounting treatment
✓ What went wrong
✓ Impact
General Risk
✓ Identify risk
✓ Explain
✓ Overall impact on FS
Impact on the financial statement of the said risk
o Understated
Lecture notes by Kevin Binoy
ACCA AA
o Overstated
o FS could be material misstated ( disclosure not given/ opening balance)
If the risk is a detection risk then we should mention it is a detection risk
Auditors Response
Procedure + Document/Process + Purpose or an Approach
When writing under or overstatement we should mention which item is under or overstating. And it
should clearly explain whether it is under stating or over stating ie. We should not write like… the
expence can be under/ overstated write either uder stated or over stated
When writing response it should be from the point of view of auditor not the management, it should
relate witht the scenario, and when a documentary evidence is available refer to it to gain full mark
Ratio analysis
Ideally depending upon the data available focus on calculating gross profit margin/ operating
profit margin, inventory holding period and receivable collection period would be ideal
three ratio
However if any of ratios above is not possible calculate current ratio or payable payment period.
Receivables days
If the question requires ideal ratios to be calculated from productive data, First priority must be given to :
1. GROSS PROFIT MARGIN
2. INVENTORY HOLDING PERIOD
3. RECEIVABLE COLLECTION PERIOD
Second priority is given to :
1. RECEIVABLES COLLECTION PEIOD
2. PAYABLES PAYMENT PERIOD
Also refer
GEARING , ROCE , CURRENT & QUICK RATIO , ASSET TURNOVER RATIO ,
Lecture notes by Kevin Binoy