Auditing - A Risk-Based Approach

Auditing AF452
Audit Risk
1-1
Audit risk
● Audit risk is the risk that the auditor expresses an inappropriate

audit opinion.
● 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, through understanding
the entity and its environment, including the entity's internal
control, thereby providing a basis for designing and
implementing responses to the assessed risks of material
misstatement.
2
Audit Risk
In conducting a thorough assessment of risk, auditors will be able to:

● Identify areas of the financial statements where misstatements are likely
to occur early in the audit.
● Plan procedures that address the significant risk areas identified.
● Carry out an efficient, focused and effective audit.
● Minimize the risk of issuing an inappropriate audit opinion to an
acceptable level.
● Reduce the risk of reputational and punitive damage.
What is a misstatement?
'A difference between the amount, classification, presentation, or

disclosure of a reported financial statement item and the amount,
classification, presentation, or disclosure that is required for the item to be
in accordance with the applicable financial reporting framework.
Misstatements can arise from error or fraud.’
(ISA 450 Evaluation of Misstatements Identified during the Audit)
Materiality
'Misstatements, including omissions, are considered to be material if they,

individually or in the aggregate, could reasonably be expected to influence
the economic decisions of users taken on the basis of the financial
statements'
(ISA 320 Materiality in Planning and Performing an Audit)
How is materiality determined?
The guidance in ISA 320 states that the determination of materiality is a

matter of professional judgement and that the auditor must consider:
● the circumstances surrounding the entity
● both the size and nature of misstatements
● the information needs of the users as a group.
Traditional benchmarks of materiality:
● 0.5 – 1% of revenue
● 5% – 10% of profit before tax
● 1 – 2% of gross assets.
Materiality is a matter of professional judgement

Performance Materiality
● The auditor sets performance materiality at a value lower than overall

materiality, and uses this lower threshold when designing and
performing audit procedures.
● In using this lower threshold, the auditor is more likely to identify
misstatements.
● This reduces the risk that the auditor will fail to identify misstatements
that are material in combination.
Audit Risk
Client Risk Under the control

of Auditor
Inherent Risk:
● The risk that arises due to the nature of the entity, its operations, and
the financial reporting environment.
● It represents the susceptibility of financial statements to material
misstatements before considering the effectiveness of internal controls.
● Example: Inherent risk might be high for a start-up technology company
that relies on complex revenue recognition methods, as there's a higher
likelihood of misstatements due to the complexity of the transactions.
Control Risk:
● The risk that material misstatements in financial statements will not be

prevented or detected on a timely basis by the entity's internal controls.
● Example: Let's say a company has an inadequate control system for
authorizing and recording financial transactions. This control deficiency
increases the risk that unauthorized transactions might occur or that
errors in financial recording might go undetected.
Detection Risk:
● The risk that auditors fail to detect a material misstatement in the

financial statements during their audit procedures.
● It's the risk that auditors' procedures do not effectively catch errors or
fraud if they exist.
● Detection risk comprises sampling risk and non-sampling risk.

Detection Risk:
● Sampling risk is the risk that the auditor's conclusion based on a sample
is different from the conclusion that would be reached if the whole
population were tested.
● Non-sampling risk is the risk that the auditor's conclusion is
inappropriate for any other reason, e.g. the application of inappropriate
procedures or the failure to recognize a misstatement.
15
Auditor’s Response
The auditor must amend the audit approach in response to risk

assessment by:
● Assigning more experienced staff to risk areas
● Increasing supervision levels
● Increasing the element of unpredictability in sample selection
● Changing the nature, timing and extent of procedures
● Increasing the emphasis on substantive tests of detail
● Emphasizing the need for professional skepticism.
Professional skepticism
'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.’ (ISA 200)
Risk assessment procedures (ISA 315 (Revised))
● Enquiries with management, of appropriate individuals within the

internal audit function (if there is one), and others (with relevant
information) within the client entity (e.g. about external and internal
changes the company has experienced)
● Analytical procedures
● Observation (e.g. of control procedures) and inspection (e.g. of key
strategic documents and procedural manuals).
Understanding the entity and its environment
Analytical procedures
Analytical procedures include comparisons of the entity’s financial

information with, for example:
● Comparable information for prior periods.
● Anticipated results of the entity, such as budgets or forecasts, or
expectations of the auditor, such as an estimation of depreciation
● Similar industry information, such as a comparison of the entity’s ratio
of sales to accounts receivable with industry averages or with other
entities of comparable size in the same industry.
https://pern-my.sharepoint.com/:f:/g/personal/muhammad_ullah_giki_edu_pk/ErzXw4UPGLtCoMmLmZ7yKHgBeqkZZ8WxZwqeQ494hjVXDA?e=qg0AZd
21
End of Chapter 1
● ACCA Paper F8 Audit and assurance - Kaplan Study Text 2020
● ACCA. Paper F8. Audit and assurance - BPP Learning Media (2015)
● ICAP Auditing and Assurance (2017)
● Alan Millichamp, John Taylor - Auditing (2021), Cengage Learning, 12th Edition
● Alvin A. Arens, Randal J. Elder, Mark S. Beasley (2012). Auditing and Assurance
Services: An Integrated Approach, 14th edition

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Auditing AF452

● Audit risk is the risk that the auditor expresses an inappropriate

● The objective of the auditor is to identify and assess the risk of

In conducting a thorough assessment of risk, auditors will be able to:

'A difference between the amount, classification, presentation, or

'Misstatements, including omissions, are considered to be material if they,

The guidance in ISA 320 states that the determination of materiality is a

Materiality is a matter of professional judgement

● The auditor sets performance materiality at a value lower than overall

Client Risk Under the control

● The risk that material misstatements in financial statements will not be

● The risk that auditors fail to detect a material misstatement in the

● Detection risk comprises sampling risk and non-sampling risk.

The auditor must amend the audit approach in response to risk

'An attitude that includes a questioning mind, being alert to conditions

● Enquiries with management, of appropriate individuals within the

Analytical procedures include comparisons of the entity’s financial

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