Q1 of AAA always relate to the audit of financial statement
Most common areas being examined will be
1. Risk ( Audit risk, risk of material misstatement or business risk)
2. Audit procedures
3. Ethics
AR (5%)
↓
Risk that auditor
may issue an
invalid audit
opinion
=
IR
↓
X
Susceptibility of
account balances
& classes of
transactions to
misstatement
irrespective of
the presence of
internal controls
CR
↓
X
Risk that
internal controls
failed to
prevent, detect
or correct
misstatement in
account
balances or
classes of
transaction
DR
↓
Risk that
auditor’s
substantive
testing failed to
detect the
misstatement in
account balances
or classes of
transaction
> 5% » Too risky
< 5% » Reduce profitability
INHERENT RISK
The business itself e.g.
restaurant
The environment in which the
client operates
Common risks:
• Revenue recognition
• Complex accounting
practices e.g. leases /
construction contract
• Inventory management
• Client’s staff are not
qualified
• Fast changes in the
technology that increase the
risk of obsolescence of client
inventories
CONTROL RISK
1. Management override the controls
2. Weak control environment i.e. client management are cost conscious or profit oriented
3. Collaboration among several staff or with third parties
4. Loopholes within the internal control system
5. Client’s operation being scattered geographically
6. The staff responsible for exercising the controls are not competent or have overlooked the
errors or frauds
DETECTION RISK
1. Audit was performed on sampling basis
2. Auditors were not familiar with the client’s nature of business
3. Audit staff sent to audit the client were not competent
4. Use of manual procedures to audit the client’s computerized accounting system
5. Auditor given a short time frame to complete the audit
6. First year of audit the client and therefore auditor lacked the prior knowledge and
experience to uncover the frauds or errors
Detection risk is high for
low risk client
DR
AR
= -----------IR x CR
DR is made the balancing figure and will be used to determine the sample size
Sample size
Reliability factor
= ------------------------Materiality level
Contrary to DR, reliability factor measures the confidence that
auditor’s substantive testing will detect the misstatements. The higher
the DR, the lower would be the reliability factor or vice versa.
Low risk client
High risk client
DR
High
Low
Reliability factor
Low
High
Sample size
Small
Large
Relationship between Audit risk (AR) and risk of material misstatement (RMM)
RMM
= AR
= IR
+
DR
CR
DR is being excluded because it relates to the
auditor NOT the financial statement
In answering audit risk and risk of material misstatement questions, it is essential that your
answer must relate to ‘how the financial statement will be affected by the risk identified and
the account balances affected i.e. overstate or understate’. Otherwise, you risk having your
answer being written as business risk.
Relationship between risk of material misstatement (RMM) and business risk (BR)
- BR are risks that the company may not achieve its goals and objectives as seen in its mission
and vision statements.
- Unlike AR and RMM, in identifying and explaining BR, you should perceive yourself as
the director of the company. BR are events that affect the company in the operational,
financial and compliance aspects.
- No mentioning of the impacts on the financial statements.
- In AAA, it is common to find the examiner testing the students both BR and RMM
concurrently. You should therefore appreciate the relationship between these two types of
risks.
E.g.
BR
1. Client’s nature of business involves
selling high technological product. Ever
since the entrance of a new competitor,
the company experiences low sales due
to increased competition.
2.
A litigation was brought against the
client by its competitor for
infringement of patent. Should the
client be found guilty, significant
compensation would have to be paid
and thus putting a strain on its
cashflow.
RMM
Considering the nature of the company’s
product, the inventory may be overstated
if no appropriate adjustment is made to its
valuation for possible obsolescence.
Client’s financial statement would be
misstated if appropriate provision or
disclosure associated with the litigation is
not made. Should the compensation be
substantial, it may even have implication
on the company’s ability to prepare the
financial statement on going concern
basis.
Whenever exam question ask you to identify business risks from the scenario given, always think of the following 3 components
1. Operational >> Highlight any situation in the client company that has the effect of threatening the smooth running of its
operation eg: breakdown in machineries. shortage of materials , high staff turnover etc.
2. Financial >> Highlight any situation in the scenario that may suggest the cash flow being threatened .eg: default in payment by
trade receivables , unfavourable movement in exchange rate, hike in the interest rate
3.Compliance >> Highlight any situation in the scenario that suggest non- compliance with the laws and regulations.