CHAPTER 7 (12 THEDITION)

/CHP 6 (13TH EDITION) -

IMPORTANT ELEMENTS OF
THE AUDIT PROCESS

.
Learning outcomes
 Elements of the audit process are explained and
discussed in various practical scenarios
 The concept of materiality is applied in a
pragmatic audit circumstances
 The components of audit risk can be identified and
applied in practical circumstances
 Auditor’s responsibilities relating to fraud in an
audit of financial statements are explained
Financial Statement Assertions
 Transactions and events (I/S)
 Balances (B/S)
Transactions and events
 Occurrence
 Completeness

 Accuracy

 Cut-off

 Classification

 Presentation
Balance sheet
 Existence
 Rights and obligations

 Completeness

 Accuracy, Valuation and allocation

 Classification

 Presentation
 The role of the International standards on
Auditing in the audit process (ISA)
Stage ISA

Preliminary 210 Agree terms of engagement

220 Quality control for and audit on f/s

Planning 300 Planning an audit of f/s

315 Id and assess the risk of material

misstatement trough understanding
the entity's environment

320 Materiality in planning and

performing the audit
Responding to risk stage 330 Audits response to assessed risk

500 Audit Evidence

530 Audit sampling

Concluding, reporting 450 Evaluating misstatement

Auditing Notes for South African Students (Jackson and Stent)

What are the inherent limitations of an
audit?
Inherent limitations of an audit Section
6.5 (13th edition ) section 7.1 (12th
edition)
 Nature of financial reporting itself- an opinion is being
formed on financial statements making a lot of
judgement, subjective decisions and assessments
 The nature of audit procedures
 Not providing complete information to auditors
 Fraud inc falsifying documents
 Auditors do not have legal powers to pursue certain
evidence as an audit is not an official investigation into
wrong doing
 Audit procedures are conducted on samples so possibility of
material mistatements
Inherent limitations of an audit Section
6.5 (13th edition ) section 7.1 (12th
edition)
 Time constraints are also a limiting factor
 Cost vs benefits. It is too costly to address all
information and pursue every matter exclusively
Audit risk (Section 6.5 13th edition/7.1
(12th edition)
 Consists of 3 components:
 Inherent risk
 Control risk

 Detection risk
Inherent risk
 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.
 Complex transactions such as complex lease
agreements are more likely to be misstated than
simple transactions such as purchasing goods
Control risk
 The risk that a misstatement could occur in an assertion
about a class of transaction, account balance or
disclosure,
 That could be material,
 individually or when aggregated with other
misstatements,
 Will not be prevented or detected and corrected on a
timely basis,
 By the entity’s internal controls.
 Control risk is a function of the effectiveness of the
design and operation of the system of internal control
Limitations of Internal Control
 Cost vs benefit-Controls may be sacrificed because of
their cost of implementation therefore increasing the risk
that misstatement goes undetected.
 Controls tend to be directed at routine transactions
rather than non-routine transactions
 Potential for human error due to carelessness,
distraction etc
 Possibility of circumvention of internal control through
collusion of management, employees or parties inside
or outside the org
 Abuse of responsibility for exercising an internal control
Limitations of Internal Control
 The possibility that procedures may become
insufficient due to changes in conditions, and
compliance with control procedure may deteriorate
e.g., internal controls cannot handle a huge increase
in sales
Limitations of Internal Control
 It is important to evaluate the presence of weaknesses
and the effect they have on the financial statements

 e.g a company has not developed cash sale

documentation and cash is not adequately recorded
and banked and there is no segregation of duties
between recording sales and banking of sales the
assertions that are affected are completeness of
sales (are all sales recorded) completeness of
bank/cash on hand is all cash accounted for
Detection risk
 The risk that 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,
 Individually or aggregated with other misstatements
Detection risk and audit procedures
 Detection risk is a function of the effectiveness of an
audit procedure and its application by the auditor,
and may arise because the auditor:
 Selects an inappropriate audit procedure and/or
 Misapplies an appropriate procedure and/or

 Misinterprets the results of the test

Detection risk and audit procedures
 Detection risk is reduced when there is compliance
with the relevant ISA’s:
 Sound planning
 Proper assignment of personnel to the engagement
team
 The application of an appropriate level of professional
scepticism
 Proper supervision and review of the audit work
performed.
Relationship between…
 Audit risk and the risk of material misstatement and
detection risk
 Risk of material misstatement and inherent and
control risk

 IR + CR= Risk of material misstatement + Detection

risk = audit risk
 Material misstatement is higher when there is a high
level of inherent risk relating to the assertion and
controls are weak
Relationship between…
 If controls are strong (Low control risk) and low inherent
risk relating to the assertion, the risk of material
misstatement relating to the assertion will be low
 Audit risk is a function of the risk of material
misstatement and detection risk e.g. if there is a high
risk of material misstatement and the auditor doesn’t
respond with effective selection and application of
audit procedures the risk of expressing an
inappropriate audit opinion (audit risk) will be very
high
Q6.2

Q1. If control risk and inherent risk are assessed by the

auditor as high, the auditor will need to ensure that
detection risk remains high if the audit risk is to be
reduced to an acceptably low level. True or false?
Justify
Q6.2

 1.False:If inherent risk and control risk are

assessed as high, the auditor must ensure
that detection risk is kept low if audit risk is
to be reduced to an acceptable level.
Q6.2

Q2. The only component of audit risk which the

auditorcan control is detection risk. True or false?
Justify.
Q6.2

 2.True: Both these risks (control and

inherent) are controlled by management
introducing appropriately designed and
executed internal controls within the
business.
Q6.2

Qn Inherent risk plus control risk equals the risk of

material mistatement. True or false? Justify
Q6.2

ANS True: The risk of material misstatement is a

direct function of control and inherent risk, e.g., if
control risk and inherent risk are low, the risk of material
misstatement is low, but will increase if either or both
control or inherent risk are assessed as medium or high.
Q6.2

4. It is only the inherent limitations of internal

control Which prevent the auditor from reducing
audit risk to Nil. True or false? Justify
Q6.2

4. False: It is the inherent limitations of the audit

function itself, including the nature of financial
reporting itself, which, combined with the inherent
limitations of internal control which make it impossible
to reduce audit risk to nil.
Understanding the entity and its
environment
 ISA 315 – Identifying and assessing the risks of
material misstatement through understanding the
entity and its environment.
 An understanding of the entity established a frame
of reference within which the auditor plans the audit
and exercises professional judgement.
Understanding the entity and its
environment to (ISA315): Section 6.3
13th edition section 7.2 (12th edition)
 Assess the risks of material misstatement of the AFS
 Determine materiality
 Consider the appropriateness of the selection and
application of accounting policies
 Identifying areas where special audit considerations
may be necessary
Understanding the entity and its
environment to (ISA315): Section 6.3
13th edition section 7.2 (12th edition)
 Developing expectations for use when performing
Analytcal Procedures
 Performing further audit procedures as response to
assessed risk of material misstatement
 Evaluating the sufficiency and appropriateness of
audit evidence obtained.
Understanding the entity section 6.2
13th edition and 7.2 (12th edition)
 Risk assessment procedures are carried out by the
auditor to gather information about the client and
assessment of risks of material misstatement at the
financial statement and assertions level can occur
Risk assessment procedures and related activities
6.2 13th edition and 7.2 (12th edition)

 Client acceptance of continuance procedures

 Previous experience with the entity

 Inquiries of management and others

 Observation of what is going on

 Inspection

 Analytical procedures

 Discussion among the audit team

Understanding the entity
 Obtaining info on:
 Industry,regulatory and other external factors
 The nature of the entity
 The entity’s selection and application of accounting
policies
 The entity’s objectives and strategies and related
business risk
 Measurement and review of the entity’s financial
performance
Table on p7/9-12 (12th edition) p6/7-6/10 (13th edition)
Understanding the entity (6.4 13 th

edition or section 7.2.5 (12th edition)

 Entity’s internal control components:
 The control environment
 The entity’s risk assessment procedures

 Information systems

 Control activities

 Monitoring of controls
Significant risk section 6.5.7 13th

edition or section 7.2.6 (12th edition)

 These are identified as risk of material misstatement
for which the assessment of inherent risk is close to
to the upper end of the spectrum of inherent risk
due to the combination of the likelihood and the
magnitude of potential misstatement
 These risks require specific audit responses and the
auditor needs to pay specific attention
Class Exercise
Lets do class example from slide 81
Homework- 2024 Graded Questions

 6.9 (materiality)
 6.8 (materiality)
 6.2 (Audit risk)
 6.16 (Audit risk)
 6.18 (Audit risk)
Materiality section 6.6 (13 th edition) or
section 7.3 (12th edition)
The auditor’s objective is to assess if there are no
material misstatements in the financial statements

Two ISAs which relate to “materiality”:

 ISA 320 – Materiality in planning and performing

an audit
 ISA 450 – Evaluation of misstatements identified

during the audit

ISA 320
 Misstatements, including omissions, are 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 AFS.
 Judgements about materiality are made in the light
of surrounding circumstances and are affected by
the size or nature of a misstatement, or a
combination of both.
Nature of Materiality
 Subjective

 Not a defined concept

 Professional judgement plays large part in the decision,
BUT
 Based on what users will consider to be an acceptable
level of misstatement.
 Different auditors are most likely to differ in their
decision when setting a materiality level
Nature of Materiality
 Relative
 What is “material” will vary from user to user and
from audit client to audit client
 Misstatements usually affect the IS and BS, but can be
material to one and not to the other.
 Instead of using a pre established amount, audit firms
use percentages of account headings or groups as a
starting point or benchmark
Nature of Materiality

Account %
heading/grouping
Net Profit before 5%
tax
Current assets 5%
Current liabilities 3%
Total assets 3%
Turnover 1%
Nature of Materiality

Example
Depreciation is misstated by R40 000
Assets = R3 000 000
Income before tax = R250 000
Nature of Materiality

Example
For guidelines of total assets 3% of R3
000000 =90 000 materiality R40 000
DEPN misstatement is not material
Nature of Materiality

Example
but would be material for guidelines of
net profit before tax (5% of R250
000=12 500) as R40 000 DEPN is
material
Nature of Materiality

Example
Most companies use net income before
tax as base to measure the materiality
of misstatement
Nature of Materiality
 Both Quantitative and qualitative
 Quantitative = when exceeding the amount which
the auditor determined as material e.g. R100000
overstatement of inventory exceeds the present
materiality of R80 000 and an overstatement of
R79 999 is not material
Nature of Materiality
 Both Quantitative and qualitative
 Qualitative = when judged against a factor other
than an amount. E.g a loan to a director of R75
000 which has inadequate disclosures
Planning materiality, performance
materiality and Final materality
 ISA320 introduces the concept of materiality at the
planning of the audit (planning materiality)
 During the audit (Performance materiality)
 Evaluation stage (Final materiality)
Planning Materiality
 Judgement about the size of misstatements that will
be considered material are assessed during the
planning of the audit
 It assists the auditor in:
 Determining the nature, timing and extent of risk
assessment procedures
 Identifying and assessing the risks of material
misstatement
 Determining the nature, timing and extent of further
audit procedures.
Planning Materiality
Planning materiality level for:
 The AFS as a whole

 Classes of transactions

 Account balances or disclosures

 Setting planning materiality for the AFS involves

quantifying the amount of misstatement that the

auditor believes could be present in the AFS without
affecting fair presentation e.g. The AFS may be out
by R1000 000 but could still be fairly presented
Planning Materiality
E.g. What is acceptable for fair presentation?
Should the AFS be 95% correct? 80% correct?
That depends on the materiality levels set
 Setting planning materiality at AFS level does not
mean much because the audit is carried out on
individual account balances, classes of transactions
and this is the level which the audit must be planned
 The next step is therefore setting planning
materiality for classes of transactions and account
headings
Planning Materiality
 Setting planning materiality for account headings
can be subjective and requires a lot of professional
judgement
 This is approached in different ways, but different
audit teams approach it in different ways
Planning Materiality
Factors to consider when quantifying planning
materiality:
 The use of benchmarks e.g., Net Profit 5%, Total assets
3%
 Importance of specific information to users e.g. a
present current ratio is needed for a bank loan and the
auditor needs to plan the audit to ensure that current
assets and current liabilities are fairly presented
 Key disclosures in relation to the industry which the
company operates e.g bonuses paid to directors need
to be disclosed in the AFS in the banking industry.
Planning Materiality
Factors to consider when quantifying planning
materiality:
 Legal requirements e.g an amount or fact that must
be disclosed in terms of JSE requirements should be
thoroughly audited to ensure that misstatement
(qualitative or quantitatve) is kept at an acceptable
level
 Opinions, views and expectations on materiality of
those charged with governance and the audit
committee
Planning Materiality
Can it be changed as the audit progresses?

 Yes, if subsequent information comes to the auditor

which would have affected the auditor’s thinking
about planning materiality, the auditor can if
necessary, change the planning material levels. E.g
if audit risk is higher or lower than what was
expected
Planning Materiality
Can it be changed as the audit progress?

 Example: AFS need to be submitted to DTI where the

client wants to borrow money and before the loan is
advanced DTI requires the AFS to reflect a certain
profit, turnover and asset “levels” as the auditor now
knows DTI relied on specific balances in the AFS,
planning materiality is then changed as there is a
higher risk of material misstatement in these balances
as there is a temptation for manipulation by the client
Performance Materiality
 Set when the auditor performs tests on specific
account balances or classes of transactions.
 In terms of ISA 320, the auditor must determine
performance materiality for the purposes of:
 Assessing the risks of material misstatement (in the class
of transactions, or account balance) and
 Determining the nature, timing and extent of further
audit procedures.
Performance Materiality
 Example
Planning materiality is R100 000
Is the auditor only interested in detecting errors
individually over R100 000?
No – R100 000 is the maximum amount or total
misstatement acceptable
The auditor should not look only at one misstatement
of R100 000 BUT that in total individual errors of R45
000, R70 000 and R13 000 EXCEED R100 000
Performance Materiality
 Performance materiality directly influences the
extent (NATURE AND TIMING) of further audit
procedures that are conducted by the audit team on
a class of transactions or account balances
 If initial assessment of risk is adjusted, performance
materiality may need to change and even the
further audit procedures required to reduce risk to
an acceptable level
Performance Materiality

Accept R250
Accept no 00 Accept R2 500 Accept R5
mistatement (MISTATEMEN 000 (3.06%) 000 000
T 0.3%) MISTATEME
NT (6.1%)

Most audit work least audit work

Planning for qualitative misstatement1

 Qualitative misstatement deals with disclosure

 Before considering planning materiality the auditor
should understand disclosures that if left out or
inadequate could influence the user’s decision
Planning for qualitative misstatement1

 Examples include
1. improper descriptions of accounting policies that
could mislead the user,
2.related party transactions,
3. director’s remuneration,
4. litigation involving the client.
 If the auditor expects qualitative mistatements, an

audit plan is formulated to address these

Final Materiality
 ISA 450:
 Evaluate the effect of the identified misstatements on
the audit
 Evaluate the effect of uncorrected misstatements if any
on the AFS.
Misstatement
 A difference
 Between the reported amount, classification,
presentation or disclosure
 Of a reported FS item and amount, classification,
presentation or disclosure
 That is required for the item to be in accordance
with the applicable accounting framework.
Misstatement
Arise from:
 An inaccuracy in gathering or processing data

 An omission of an amount or disclosure (inc

inadequate or incomplete disclosure)
 An incorrect accounting estimate arising from
overlooking, or clear misrepresentation of facts
 Judgements of management concerning accounting
estimates that the auditor considers unreasonable or
the selection of accounting policies which the auditor
considers inappropriate
Misstatement
Arise from:
 Error

OR
 Fraud

 An inappropriate classification, aggregation or

disaggregation of information
 For more on misstatement see sec 7.3.4.2 (12
th

edition or 6.6.4.2 (13th edition)

Consideration of misstatements as the
audit progresses
 The auditor should monitor how the audit is going in
respect of what that the auditor expected and what
is reflected by the materiality levels and audit
strategy and plan that were put in place
 If misstatements identified are not going as
expected or planned, the auditor may need to
revise the audit strategy and plan
Evaluating the effect of identified
misstatements on the audit
 This is about making the final materiality decision
and the auditor needs to decide what happens to
any uncorrected mistatements
 Monitoring how the audit is going in respect of what
the auditor expected and what is reflected by the
materiality levels and audit strategy and plan.
 Can revise the audit plan to extend audit testing.
Evaluating the effect of uncorrected
misstatements on the AFS
 Final materiality decision – what to do with the
uncorrected misstatement
 Will the uncorrected misstatements influence the
decision of a user?
 Analyse and project the errors in the sample over
the population sampled
 If a statistical basis is used for selecting the sample,
the appropriate statistical method for projecting the
error in the sample over the population will be used
Evaluating the effect of uncorrected
misstatements on the AFS
 Most audit firms use a proportional projection method e.g

 Error value in sample x total value of population

total value of sample

This is to obtain an idea of the extent to which the population

is misstated if the projected misstatement is unacceptable, the
auditor must
1) Decide whether the audit team should carry further tests or
whether the client can check the population in detail for errors
Evaluating the effect of uncorrected
misstatements on the AFS
Discuss all misstatements with Management to have them
corrected. The reasons why management may not want them
corrected is because:
 Disagreement that there is a misstatement e.g inventory
obsolesence
 Not regard misstatement as material and will influence a
user’s decision
 Have ulterior motives e.g dir want to achieve particular
ratios
 Regard it as too much hassle to make the changes e.g
changes would mean changing income statement
 Be unconcerned about receiving a qualified audit opinion
Factors to be considered in evaluating uncorrected
misstatements-Factual misstatements

 Misstatement
 That the auditor (and therefore client)
 Can clearly identify and substantiate with supporting
evidence
 E.g sales invoices which have been included in the
wrong period
 Misstatements for which there is NO doubt
 An auditor will be more forceful in requesting that the
error is corrected and if the client refuses, the auditor is
on strong ground to qualify the audit opinion.
Judgemental misstatements
 Difference
 Arising from the judgements of management
 Concerning accounting estimates
 That the auditor considers unreasonable,
 Or the selection and application of accounting
policies
 That the auditor considers inappropriate.
Projected misstatements
 A projected misstatement is the auditor’s best
estimate of misstatements in populations
 Involving the projection of misstatements identified
in audit samples
 Over the entire population from which the samples
was drawn.
Projected misstatements
 Where it is a judgemental or projected
misstatement the auditor will have to be less
forceful and open to further discussion with
regard to insisting on correction and qualifying
the report, because of the error’s subjective
nature
Offsetting uncorrected misstatements

 Theoretically unsound
 Overstatement can not be offset against

understatement
Example
Inventory is overstated by R100 000, and Debtors is
understated by R120 000 you cannot offset these two
amounts
Circumstances to evaluate misstatements which
may not be material

 Affects compliance with regulatory compliance e.g

omitting Dir remuneration
 Affects compliance with debt covenants or other
contractual requirements e.g. misstating inv may
affect compliance with a loan contract stating that
inv should not exceed a certain amount or %
 Impacts ratios or trends e.g. Earnings per share
Circumstances to evaluate misstatements which
may not be material

 Has the effect of increasing management earnings

e.g paying bonuses based on net profit before
taxation
 Relates to items involving related parties e.g.
contracts with Co’s director has a financial interest
 Reflects a level of dishonesty by the directors e.g.
an unauthorized loan of R75 000 has been hidden
in AR even though it is below R100000 Materiality
level
Factors to be considered in evaluating in
evaluating uncorrected misstatements

 Misstatements should not be considered in isolation

e.g all individual misstatements should be added up
together to reflect the mistatement
Should final materiality equal planning
materiality?

 Final materialty should be equal to planning

materiality eventually used during the audit
 It might not be the auditor’s initial planning
materiality as it can be changed by the auditor
progresses but the planning materiality eventually
used is the auditor’s best estimate of misstatement
the users of the AFS will accept
Class exercise
 Audit risk Class exercise 2
Homework
 6.7
 6.9
 6.13
Question-Audit risk
Your firm was recently appointed as the external
auditor (Detection – we don’t know the client) for the
year ending 30 April 2019 of TakeItCheap Limited
(TIC). TIC is an online-retail (Detection Risk – We
don’t have sufficient resources because it’s a
specialized environmnent)shop selling anything
you(Inherent Risk- Theft, Obsolescence) (Control Risk-
They might not be able to keep up with stock)can
imagine, from laptops to lawnmowers.
Question-Audit risk
During the planning phase of your audit, you have
identified the following:
1. TIC has warehouses in Johannesburg, Mbombela,
Polokwane, Bloemfontein, Durban and Cape Town. Due
to Covid, one of the branches had to shut-down
temporarily during the audit period.
2. 2. TIC has their own internal audit function to evaluate
the effectiveness of the internal controls. The
Internal Audit function improved some of the controls
to make it more efficient to calculate vat. The
internal audit policy was amended.
Question risk
3. The Chief Financial Officer is currently on
leave pending the outcome of an investigation
of his involvement in tender fraud. The accounting
clerk will be taking over his responsibilities
pending the outcome of the case.
4. TIC has obtained a R100 million-rand loan from
Capitake Bank to finance the building of a state-
of-the-art warehouse. If the new warehouse is
completed this year, management will get a bonus.
The loan conditions included:
 Maintaining a current ratio of 2:1
Question-Audit risk
You are required to:
Identify the impact that the above information will
have on your assessment of audit risk by completing
the table below:
Audit risk component Impact (increase/decrease) on Reason (Why?)
affected the audit risk component affected
(6 marks)
(6 marks) (6 marks)
1
.
2
.
3
.
4
.
5
.
6
.
Question-Audit risk
You are required to:
N
o
.
Audit risk Impact Reason
componen (increase/decr (Why?)
t affected ease) on the
audit risk
(6 marks) component (6 marks)
affected
(6 marks)
1
.
2
.
3
.
4
How to answer
 First of all understand the components of audit risk
Inherent risk- “built in risk” e.g. inventory of diamonds
as an expert will be required, complex lease
transactions
Control risk
Detection risk
No.
Scenario
Audit risk Impact Reason (Why?)
component (increase/decr
affected ease) on the
audit risk (6 marks)
(6 marks) component
affected
(6 marks)
1.

Detection Increase(1) TIC is a new audit

risk (1) client – the auditors is
not that familiar with
the business and
control environment
yet. (1)
 Scenario
N Audit risk Impact Reason (Why?)
o component (increase/de
affected crease) on
the audit risk (6 marks)
(6 marks) component
affected
(6 marks)
1.
2. Inherent Increase(1) Wide variety of inventory
risk(1) and large inventory levels to
meet needs of customer –
risk of theft and
obsoleteness of inventory.
(1)
 Scenario
No. Audit risk Impact Reason (Why?)
componen (increase/d
t affected ecrease) on
the audit (6 marks)
(6 marks) risk
component
affected
(6 marks)
1.
2.
3. Inherent risk(1) Increase (1) Due to the nature of the
business warehouses across
No.
Scenario
Audit risk Impact Reason (Why?)
component (increase/decr
affected ease) on the
audit risk (6 marks)
(6 marks) component
affected
(6 marks)
1.
2.
3.
4.
Control risk(1) Increase(1) Controls may be
different at the different
locations as it is
managed by different
people. (1)
Scenario
No. Audit risk Impact Reason (Why?)
component (increase/decreas
affected e) on the audit
risk component (6 marks)
(6 marks) affected
(6 marks)

5. Detection risk Increase (1) Due to the many warehouse

(1) locations it will be impossible
for the audit team to attend
all inventory counts. Material
misstatements during the
inventory count might remain
undetected. (1)
Scenario

7. Control risk(1) Increase(1) The CEO (Control

environment) appears to
behave unethical – being
investigated for tender
fraud. (1)
8. Inherent risk(1) Increase(1) TIC may manipulate
financial statements to
ensure that the loan
conditions are met. (1)
9. Detection Increase(1) Due to the tight deadline the
risk(1) auditors might fail to detect
material misstatements in
the financial statements. (1)