Audit objectives and the audit risk model

Accounting Ahead | Original study resource | accountingahead.com.au

Audit objectives and the audit risk model

MODULE 2 | 2.1.1 | STUDENT COMPANION

An audit exists to increase the confidence that intended users can place in the financial statements,

through an opinion based on reasonable assurance. Management prepares the statements and runs the

controls; the auditor gives the opinion. Audit risk combines the client's risks of material misstatement

(inherent risk and control risk) with the auditor's own detection risk, and only detection risk is in the auditor's

hands.

Why an audit exists

Users such as shareholders and lenders can't check the statements for themselves, so an independent opinion

raises the confidence they can place in them. For an Australian company, the opinion covers whether the

statements are true and fair and comply with the accounting standards. The auditor aims to obtain reasonable

assurance that the statements as a whole contain no material misstatement, from either fraud or error, and then

reports and communicates as the standards require. Reasonable assurance is high, but never a guarantee.

Who is responsible for what

Management, overseen by the directors The auditor

Prepares the statements in line with the applicable

framework

Plans and performs the audit to obtain reasonable

assurance

Runs the internal control needed to prepare statements free

from material misstatement

Forms and expresses the opinion; reports and

communicates as the standards require

Gives the auditor access to all relevant information and

people

Stays independent: fixing the client's accounts would mean

checking its own work

Meet Voltana Energy Ltd (imagined)

Fact Why it matters to the audit

ASX-listed; 30 June year end; home batteries assembled in Brisbane Investors watch its results closely

Imports cells and inverters, paying its suppliers in US dollars Exchange rates flow into inventory cost

Own commissioned sales team and partner electricians sell and install Revenue depends on installation, not signing

Ten-year performance warranty on every battery A large provision built on judgement

Revenue about $240m (last year $180m); profit before tax about $12m Fast growth strains systems and people

New accounting and operations system from February; bonuses tied to

30% revenue growth

Untried controls; an incentive to bring sales

forward

The founder and chief executive owns a large stake and the company

that leases Voltana its factory

A related party lease to disclose

$60m bank facility with strict conditions; audited for five years by Linden

Ridge Partners (imagined)

Pressure to meet the bank's terms; familiarity to

manage

ADVANCED AUDIT AND ASSURANCE | M2 | 2.1.1 | STUDENT COMPANION

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Accounting Ahead | Original study resource | accountingahead.com.au

How audit risk is built

Audit risk

The risk of giving the wrong opinion on statements that

are in fact materially misstated

combined with

Risks of material misstatement

The client's: they exist before the auditor arrives

Inherent risk

How susceptible an assertion is to

misstatement before any controls

Control risk

The client's controls won't stop a

misstatement, or catch and correct it,

in time

Detection risk

The auditor's: its own procedures fail to detect

a misstatement that exists. The only part the

auditor can change

The risks of material misstatement are assessed at two levels

Financial statement level

Pervasive: affects the statements as a whole and many assertions at

once. At Voltana: a new system that feeds almost every account

Assertion level

A particular account balance, class of transactions or disclosure. At

Voltana: the valuation of the warranty provision

Two levels. A financial statement level risk is pervasive: it touches many assertions at once and can't be

pinned to one account, such as pressure on management to hit a target. An assertion level risk sits in a

particular account balance, class of transactions or disclosure, and for each one the auditor assesses inherent

risk and control risk separately.

The five inherent risk factors at Voltana

Complexity

Converting US dollar

purchases and costing

batteries built from

imported parts:

calculations that are

easy to get wrong

Subjectivity

The warranty provision

rests on management's

judgements about

future failure rates

Change

The new system went

live mid-year, and

changes to data and

processes often create

errors

Uncertainty

Nobody knows how the

newer battery design

will perform over ten

years

Bias or fraud

Bonuses tied to 30%

revenue growth create

an incentive to record

sales too early

The fifth factor in full: susceptibility to misstatement through management bias or fraud

Each risk sits on a spectrum: how likely a misstatement is, and how large it could be

Lower end Upper end: significant risks

Significant risks need special audit attention

The spectrum of inherent risk. Each risk is judged by the likelihood of a misstatement and its possible

magnitude, with the five factors explaining why an assertion is exposed. A risk at the upper end of the spectrum

is a significant risk, which receives special audit attention later in this module.

ADVANCED AUDIT AND ASSURANCE | M2 | 2.1.1 | STUDENT COMPANION

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Control risk

Control risk is the chance that the client's controls won't prevent a material misstatement, or won't detect and

correct it in time. At Voltana the new system raises it: its controls are untried, and any errors in the data moved

from the old system could flow straight into the accounts. The assessment rests on testing. If the auditor

doesn't plan to test whether a control operates effectively, it can't assume the control works, so the assessed risk

of material misstatement is simply the assessment of inherent risk. Both risks belong to the entity, and managing

them is management's job.

The detection risk grid

Control risk assessed as

High Medium Low

Inherent risk

assessed as

High

Very low

detection risk

Low

detection risk

Moderate

detection risk

Medium

Low

detection risk

Moderate

detection risk

High

detection risk

Low

Moderate

detection risk

High

detection risk

Very high

detection risk

Acceptable detection risk in each cell

Both risks high: the lowest detection risk, so

the most persuasive evidence

More tests of details

Larger samples

Work at or near the year end

More evidence from outside the entity

Both risks low

The auditor can accept a higher detection risk and do less,

though material items always get some substantive work

The relationship is inverse

Detection risk is the chance that the auditor's procedures miss a misstatement that exists. The auditor can't

change the client's risks, so it changes the nature, timing and extent of its procedures: the higher the assessed

risks, the lower the detection risk it can accept, and the more persuasive the evidence must be.

Putting a number on it (illustration only)

The standards set no percentage for acceptable audit risk, and auditors normally use words such as low,

medium and high. The arithmetic only shows why weak controls and risky accounts make an audit bigger.

Situation Risk of material

misstatement

Acceptable detection

risk

Audit risk

Voltana's revenue as assessed About 50% About 10% 50% x 10% = 5%

If better controls halved the risk About 25% About 20% 25% x 20% = 5%

ADVANCED AUDIT AND ASSURANCE | M2 | 2.1.1 | STUDENT COMPANION

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Practice questions

MODULE 2 | 2.1.1 | TRY THESE BEFORE THE WORKED ANSWERS

Question 1 - Name the factor and the level

Ardlow Cheese Ltd (imagined) is a listed cheese maker with a 30 June year end. For each fact, name the

inherent risk factor it represents, and say whether it creates a risk at the financial statement level or for a

particular assertion (name the assertion).

Fact Inherent risk factor Financial statement level, or

which assertion?

(a) Cheese matures for 6 to 24 months, and the cost of

each batch includes milk, labour and a share of factory

overheads spread across the maturing period.

(b) The final price paid to dairy farmers for this year's

milk won't be set until September, so at 30 June

management must estimate the extra amount it will owe

them.

(c) Management judges how much of the cheese now

maturing will reach premium grade, which decides the

price it will sell for.

(d) A new accounting and inventory system went live in

January, and all inventory and payroll data were moved

across from the old system.

(e) The chief executive and the finance director earn

bonuses of up to 80% of salary if earnings before

interest and tax grow by 15% or more.

(f) About 40% of sales are exports invoiced in US

dollars, and the company uses forward exchange

contracts to protect its margins.

ADVANCED AUDIT AND ASSURANCE | M2 | 2.1.1 | STUDENT COMPANION

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Question 2 - Rank the accounts

Using the facts in Question 1, rank these four Ardlow accounts from highest (1) to lowest (4) risk of material

misstatement, and explain your ranking.

Account Rank (1 =

highest)

Why

Inventory of maturing cheese

Amount owed to farmers for the

final milk price

Trade receivables from export

customers

Cash at bank

Question 3 - Use the risk grid

Use the detection risk grid to decide the acceptable detection risk for each Ardlow account, and describe the

evidence each would need.

Account and assessments Acceptable

detection risk

Evidence needed

(a) Inventory. Inherent risk high. Control

risk high: the new system's controls

haven't been tested.

(b) Amount owed for the final milk

price. Inherent risk high. Control risk

medium: the board reviews the estimate,

but only against management's own

assumptions.

(c) Cash at bank. Inherent risk low.

Control risk low: daily bank feeds and

monthly reconciliations, with the controls

tested and found effective.

ADVANCED AUDIT AND ASSURANCE | M2 | 2.1.1 | STUDENT COMPANION

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Worked answers

MODULE 2 | 2.1.1 | WORKED ANSWERS - ATTEMPT THE QUESTIONS FIRST

Question 1 - Ardlow Cheese

Factor Level and assertion

(a) Complexity Assertion: accuracy, valuation and allocation of inventory (and cost of sales)

(b) Uncertainty, with some

subjectivity

Assertion: completeness and valuation of the amount owed to farmers, and the

cost of sales it feeds

(c) Subjectivity Assertion: valuation of inventory, as cheese that misses premium grade may sell

for less than it cost

(d) Change Financial statement level: the system feeds many accounts, so errors in the

moved data could affect many assertions at once

(e) Susceptibility to management

bias or fraud

Financial statement level: the incentive could push any judgemental figure,

especially revenue and the estimates in (b) and (c)

(f) Complexity Assertion: accuracy of export sales and receivables converted from US dollars,

and valuation of the forward contracts

Some facts fit more than one factor: what matters is explaining why the item is exposed.

Question 2 - Ranking (suggested)

Rank Account Why

1 Inventory of maturing

cheese

Large, and exposed to three factors at once: complex costing, subjective grading and

data moved into a new system. Overstating it also lifts profit and bonuses.

2 Final milk price owed Uncertain and subjective, and an under-estimate lifts earnings, so the bonus adds a

bias risk. A single figure that can be checked against the September price.

3 Export receivables Some complexity from US dollars, but balances can be confirmed with customers

and checked against cash received after year end.

4 Cash at bank Little judgement, and easily confirmed with the bank.

Ranks 1 and 2 could be swapped: the reasoning is what counts.

Question 3 - Using the grid

Detection risk Evidence needed

(a) Inventory Very low Most persuasive evidence: attend the 30 June count and test counts both ways;

recalculate costing and overheads; check grading against prices after year end;

agree balances moved into the new system; larger samples.

(b) Final milk price Low Compare the estimate with the price announced in September; recalculate litres

times the expected price; read the supply contracts; check last year's estimate

against the outcome for bias.

(c) Cash at bank Very high Less work: a bank confirmation sent directly to the auditor and a check of the

year-end reconciliation. A material balance always gets some substantive work.

ADVANCED AUDIT AND ASSURANCE | M2 | 2.1.1 | WORKED ANSWERS

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