PART D - PLANNING AND CONDUCTING AN AUDIT

OF HISTORICAL FINANCIAL INFORMATION

SESSION 7
 ISA 300 – planning
 Planning Process
 ISA 260 - Communications With TCWG
 ISA 265 - Communicating Deficiencies In Internal Controls To
TCWG
 Significant Deficiency

SESSION 8
 Risk of Material Misstatement
 ISA 320 - Materiality
 Performance Materiality
 Revision of Materiality
 ISA 315 – Identifying And Assessing The ROMM Through
Understanding The Entity& It’s Environment
 ISA 520 - Analytical Procedures
 Ratio Analysis
 ISA 330 - Auditor’s Response to Assessed Risks
 Audit Procedures
 ISA 450 - Evaluation of Misstatements Identified during Audit
 Evaluation of Uncorrected Misstatements
 Types of Misstatements

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 SESSION 8 – RISK ASSESSMENT

RISK OF MATERIAL MISTATEMENT

AUDIT RISK

Audit risk is defines as ‘the risk that the auditor expresses an

inappropriate audit opinion when the financial statements are materially
misstated’

Formula for audit risk is:

Audit Risk = Inherent Risk x Control Risk x Detection Risk

Risk of Material Misstatement

Inherent Risk
This is the susceptibility of an assertion about a class of transaction,
account balance, or disclosure to a misstatement that could be material,
either individually or when aggregated with other misstatements, before
consideration of any related controls.
For Example,
Fast moving Industry

 This industry is a fast changing industry such as the fashion or IT

industry. So there is high chance that there may be obsolete
inventory in the company. Therefore there is a risk that the
inventory valuations in the company may not have been done
appropriately.

 The auditor may take expert advice on the valuation of inventory,

or they may review post year-end sales to ensure the goods are
sold for more than they are valued at in the financial statements.

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 Control Risk
This is the risk that a misstatement could occur in an assertion about a
class of transaction, account balance or disclosure, and that the
misstatement could be material, either individually or when aggregated
with other misstatements, and will not be prevented or detected and
corrected, on a timely basis, by the entity’s internal control.
To put it simply, it is the risk that the internal controls within the
organisation does not detect a material misstatement.
For Example,
No controls over access to assets

 If employees have access to the assets of the business with no

restrictions, this will increase the risk of theft or damage to those
assets.

Detection Risk
This 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, either individually or when aggregated
with other misstatements.
Detection risk includes sampling as well as non-sampling risk
Sampling risk

 ‘The auditor’s conclusion, based on a sample may be different

from the conclusion reached if the entire population were
subjected to the same audit procedure’.

 Basically, the sample selected will not be representative of the

population from which the sample was selected

Non-sampling risks

 This caused due to factors other than sampling risk

 The auditor did not sufficiently investigate a significant balance
 The procedures used may have been inappropriate or
misinterpreted

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 BUSINESS RISK

‘A risk resulting from significant conditions, events, circumstances,

actions or inactions that could adversely affect an entity’s ability to
achieve its objectives and execute its strategies, or from the setting of
inappropriate objectives and strategies.’

ISA 320 - MATERILAITY

According to ISA 320 ‘an omission or misstatement is considered to be

material, if they individually or in aggregate could reasonably be
expected to influence the economic decisions of users taken on the
basis of the financial statements.’
Material items are significant transactions and events
Materiality is important to an auditor because, if the financial statements
contain material misstatement they cannot be deemed to show a true
and fair view.

MATERIALITY LEVELS
The materiality level is determined by the auditors on the basis of
professional judgements. The auditors consider the following –
 Does the misstatement affect the economic decision of the users?
 What is the size and nature of the misstatement?
 Information needs of the users

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 The following benchmarks and percentages may be appropriate in the
calculation of materiality for the financial statements as a whole:

Value %
Revenue ½–1
Total assets 1–2
Profit before tax 5–10

APPLYING PROFESSIONAL JUDGEMENT TO DETERMINE THE

MATERIALITY LEVELS
You need to look at the –
o Quantity
Here the magnitude of the item is looked at
Does the relative size of the item exceed the financial threshold or
benchmarks?
o Quality
Here the nature and circumstance of the item is looked at
There are items that are material even though the value of the item
does not exceed the financial threshold or the benchmarks. These
are for example, the director’s wages, a misstatement that can turn
an asset into a liability, a profit into a loss, etc.

PERFORMANCE MATERIALITY

Performance materiality is 'the amount or amounts 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'.
This will be lower than the normal materiality.
This reduces the risk that the auditor will fail to identify misstatements
that are material when added together

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 Specifically, the revised ISA 320 suggests performance materiality be
applied to areas such as related party transactions and directors’
remuneration.

REVISION OF MATERIALITY

The level of materiality must be revised for the FS as a whole if the

auditor becomes aware of information during the course of audit that
would have caused the auditor to determine a different amount during
planning

ISA 315 – IDENTIFYING AND ASSESSING THE ROMM THROUGH

UNDERSTANDING THE ENTITY& IT’S ENVIRONMENT

WHY SHOULD WE LOOK AT IT?

 To identify and assess the risks of material misstatement at the

financial statement level and at the assertion level

 To enable the auditor to design and perform further audit

procedures

 To provide a frame of reference for exercising audit judgement,

for example, when setting audit materiality

WHAT SHOULD WE LOOK AT?

 Industry, regulatory and other external factors, including the

applicable financial reporting framework

 Nature of the entity, including operations, ownership and

governance, investments, structure and financing

 Entity's selection and application of accounting policies

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  Objectives and strategies and related business risks that might
cause material misstatement in the financial statements

 Measurement and review of the entity's financial performance

 Internal control

HOW CAN WE DO THAT?

 Analytical Procedures
 Enquiry with Management
 Inspection
 Observation
 Prior period knowledge
 Client acceptance or continuance procedures
 Discussions between the audit team
 Information from other engagements undertaken for the entity

WHERE CAN WE GET THAT INFORMATION?

 Permanent audit file
 Website
 Publications
 Previous year’s audit file
 Board minutes
 Budgets and Forecasts

ISA 520 - ANALYTICAL PROCEDURES

‘Evaluations of financial information through analysis of plausible

relationships among both financial and non-financial data and
investigation of identified fluctuations, inconsistent relationships or
amounts that differ from expected values.’
Analytical procedures can only identify the source of misstatements
rather than the misstatement itself. Therefore, involves great deal of
professional judgment.

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 Comparison of:
 Similar information of prior period
 Predictions prepared by auditor
 Budgets or forecasts
 Industry information
 Ratio analysis
 Trend analysis
 Reasonableness test
 Examining related accounts –
 Receivables and sale
 Payable and purchases
 Receivables and bad debts
 Non-Current Asset and depreciation
 Loan and finance cost

Analytical Procedures are used at the following stages of the audit

 Planning stage – for identifying and assessing the ROMM through

(ISA 315)

 During audit – Risk assessment procedure, Substantive Procedures

(ISA 315)

 Review stage – Overall conclusion that FS are consistent with the

auditor’s understanding

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 RATIO ANALYSIS

RATIOS CALCULATION

Profitability Ratios

Profit Before Interest and Tax (PBIT) /

Return On Capital Employed (Share capital + Reserves + Non -
(ROCE): Current Liabilities)

Net Profit Margin PBIT / Revenue

Revenue / (Share capital + Reserves +

Asset Turnover
Non -Current Liabilities)

Gross margin Gross Profit / Sales Revenue

Liquidity Ratios

Current Ratio Current Assets / Current Liabilities

Current Assets – Inventories / Current

Quick Ratio (Acid Test)
Liabilities

Inventory Holding Period Inventory × 365 / Cost of Sales

Trade Receivables × 365 / Credit

Receivables Collection Period Sales

Trade Payables × 365 / Credit

Payables Payment Period
Purchases

Gearing Ratios

Interest bearing Debt / Share Capital &

Debt / Equity
Reserves

Interest Cover PBIT / Finance Cost

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 ISA 330 - AUDITOR’S RESPONSE TO ASSESSED RISKS

The ISA states that ‘The auditor shall design and perform audit
procedures whose nature, timing and extent are based on and are
responsive to the assessed risks of material misstatement.’

ROMM

Responses- Audit
procedures

Sufficient appropriate
audit evidence

AUDIT PROCEDURES

Test Of Controls Substantive Procedures

Tests of controls are designed to Substantive procedures are

evaluate the operating designed to detect material
effectiveness of controls in misstatement at the assertion
preventing , detecting or level.
correcting the material
misstatements at assertion level Test Of Details - verifies individual
transactions and balances.

Analytical Procedures- involve

analysing relationships between
information to identify unusual
fluctuations which may indicate
possible misstatement.

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 ISA 450 - EVALUATION OF MISSTATEMENTS IDENTIFIED DURING
AUDIT

 Accumulate a record of all identified misstatements, unless they

are clearly trivial.

 Consider if the existence of such misstatements indicates that

others may exist, which, when aggregated with other
misstatements, could be considered material.

 If so, consider if the audit plan and strategy need to be revised.

 Report all accumulated misstatements to an appropriate level of

management on a timely basis and request that all misstatements
are corrected.

 If management refuses to correct some or all of the misstatements

the auditor should consider their reasons for refusal and take these
into account when considering if the financial statements are free
from material misstatement.

EVALUATION OF UNCORRECTED MISSTATEMENTS

● Reassess materiality to determine whether it is still appropriate in

the circumstances as the level of risk may be deemed higher as a
result of management’s refusal.

● Determine whether the uncorrected misstatements, either

individually or in aggregate, are material to the financial statements
as a whole, considering both the size and nature of the
misstatements and the effect of misstatements related to prior
periods (e.g. on corresponding figures, comparatives and opening
balances). If an individual misstatement is considered material it
cannot be offset by other misstatements.

● Report the uncorrected misstatements to those charged with

governance and explain the effect this will have on the audit
opinion.

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 ● Request a written representation from those charged with
governance that they believe the effects of uncorrected
misstatements are immaterial.

TYPES OF MISSTATEMENTS

Factual misstatements: factual means that it is true. A misstatement

about which there is no doubt.
Judgmental misstatements: a difference in an accounting estimate
that the auditor considers unreasonable, or the selection or application
of accounting policies that the auditor considers inappropriate.
Projected misstatements: a projected misstatement is the auditor’s
best estimate of the total misstatement in a population through the
projection of misstatements identified in a sample.

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