Chapter 5

Audit Risk
AUDIT AND ASSURANCE

Audit risk is the risk that the auditor expresses an inappropriate opinion when the financial
statements are materially misstated.
If that happened will lead to : Sued by intended user, Damage of Reputation, Disciplined Actions
To Avoid that you need to do the following Steps:
Planning > understand the business > Risk Assist > Design Audit Procedures > obtain Evidence >
Reduce Audit Risk to an acceptance low level
Management Risk Auditor Risk
Audit risk = Inherent Risk X Control Risk X Deduction Risk
risk of material misstatement
Risk of material misstatement
Is the risk that the financial statements are materially misstated prior to the audit; this will be due to fraud or errors.
(Related to management)

Misstatement:
A difference between
the amounts, classification, presentation, or disclosure of a reported financial statement item and
the amounts, classification, presentation, or disclosure accordance with IFRS framework.

Categories of misstatements:
▪Factual misstatements: misstatement about which there is no doubt.
▪Judgmental misstatements: difference in an accounting estimate that the auditor considers unreasonable.
▪Projected misstatements: the percentage of errors in sample size is not matched with the percentage of errors in Population

The risk of material misstatement comprises inherent risk and control risk.
Inherent risk:
▪Inherent risk the susceptibility of an assertion about a class of transaction, account balance or
disclosure to material misstatement, before consideration of any related controls.

Uncertainty Ex: Going Concern

EX: provision,
Management Bias. Revenue
overstated

IFRS

Complexity
Factors
Industry

regulation

Change
BM
Ex: from ratal to
manufactory
Subjectivity
Control risk:
the risk that is MM that could occur and will not be prevented, or detected and corrected on a
timely basis by the entity's internal controls.
Controls ➞ Should eliminate or Reduce the Risk

▸Prevent

Adequate ▸Deduct
Effective CR Low Risk

Controls
▸ Correct
Controls

Design Manuals
▸Not Prevent Ineffective CR High Risk
Effective
Operating Inadequate ▸Not Deduct
Ineffective
▸Not Correct

Ex: Cash
Control Design: Conducting a treasury stocking, bank reconciliation, Treasury insurance, 2 or more signatures on cheques
Operating: How the management commitment to this control.

Deduction Risk:
The procedures performed by the auditor to reduce the Audit Risk -to an acceptance low level- not
deduct the Material Misstatement

DR

Sampling size Non-sampling size

Sample size tested = 10% Risk that the Auditor’s conclusion is inappropriate for any reason
Conclusion ≠ Conclusion else.
Reason:
That would be reached if population tested 15% 1) Frist year Audit
2) Time Pressure (Rush Audit)
NOT REPERSINTIVE 3) Client multiple Site (many branches)

How to Reduce Audit Risk Reduce Deduction Risk

1) Large Size samples
2) More experienced staff to complex or risky areas
3) More supervision.
4) Less reliance on the results of systems and controls testing.
5) More substantive procedures.
6) Experts on technically complex ( ECL, Algaculture , Exploration , insurance provisions )
7) Professional skepticism
‫متخدش أي معلومة‬
‫بشكل مسلم بية‬
Attitude that includes questioning mind alert
which may indicate possible misstatement

Professional skepticism requires the auditor to be alert to :

1) Audit evidence that contradicts other audit evidence
2) How reliability of documents and responses to enquiries
3) Conditions that may indicate possible fraud or Error
4) Circumstances that suggest the need for addition audit procedures

Risk assessment
The process of identifying preventive and protective measures by evaluating the risk arising from a hazard
taking into account the adequacy of any existing controls and deciding whether or not the risk is acceptable
Benefits of Risk Assessment
1) Identify the area of Financial Statement that high Risk of MM
2) A Plan Procedures to address the significant Risk
3) Cost and time effective Audit can be carried out
4) Reduce Risk of issuing of inappropriate audit opinion
5) Reduce Risk of reputation damage
 Risk assessment
Understanding

Entity Environment IFRS System of Internal

Control
1) Structure 1) Industry Conditions 1) Revenue Recognition
2) Governance 2) New regulations 2) Financial Instruments 1) Risk Assessment Process
3) Business Model 3) Completion 3) Foreign Currency 2) Info. System or Manual
4) Business Risks 4) Economic Conditions 4) New IFRS 3) Control Activity
5) Change in Key Personnel 5) Cyclical or Seasonal Activity 5) Complex Transaction 4) Internal Audit committee or not
6) Key customers and suppliers 6) Leck of Guidance (ECL) 5) Control deficiencies or not
7) Incentive & Pressure
Source of INFO.
Audit Firm: Experts, Last year Data Client: Website, Dissections Analytical Procedures: Ratios :YOU Your experience

Inquire Enquiries with management and internal audit committee about key changes in the company

Observation Control Your observations while you are in the company, Example: the treasury in unsafe place
Procedures

Inspect for all Document: Natives HR Record Media bored Minutes Audit committee
Inspection
‫معقولة‬
Evaluations of financial information through analysis of plausible relationships between both
Analytical
financial and non-financial data and investigation of:
Procedures
① Fluctuations ② Inconsistent relationships ③ Amounts that differ from expected values.

Unplausible relationships between financial and non-financial data Example:

Market Share: ⬆ increased Revenue: ⬇ Decreased

Desc 2020 2021 Diff % Desc 2020 2021 2022

Revenue 5,000,000 6,000,000 1,000,000 20% ②

Procedures

% 9% 10% 45% ①
Inconsistent
COGS 3,000,000 3,300,000 300,000 10% relationships Revenue 5,000,000 5,500,000 8,000,000
fluctuations

Direct Relation Ship between Revenue and COGS

Expected Actual ③
Asset Dep. Rate Diff %
Amount Amount Amounts that
differ from
1,000,000 10% 100,000 80,000 20,000 20%
expected values

Important of analytical procedures as risk assessment:

1) Identify unusual transactions that might indicate of material misstatement
2) Help Identifying risks of material misstatement due to fraud
3) assessing the risks of material misstatement
4) Identify aspects of the entity of which the audit was unaware

Analytical Procedures Components

Comparison Relationships
• Comparable information for prior periods Related Figures Fin & Non-Fin Data
• Expected results of the entity, such as budgets • Revenue ⬆ COGS ⬆ Inventory ⬇ • Acquisition Revenue ⬆
• Expectations of the auditor, such as estimation of dep. • Revenue ⬆ AR ⬆ Inventory ⬇ • # of employee ⬆ Payroll ⬆
• Similar industry information • COGS ⬆ AP ⬆ Purchase ⬆ Inventory • Market Share ⬆ Revenue ⬆

Ratios

Profitability ratios Liquidity ratios Efficiency ratios Investor ratios

Profitability ratios:
• Net Profit Margin = Net Profit ÷ Sales Revenue × 100%
• Gross Profit Margin = Gross Profit ÷ Sales Revenue × 100%
• Operating Profit Margin = Operating Profit ÷ Sales Revenue × 100%
For example, if Abnormal improves in gross profit margin, this could be caused by any or all of the following unusual Fluctuations :
➜ Overstated revenue because of inappropriate revenue recognition.
➜ Understated cost of sales because of incomplete recording of purchases.
➜ Understated cost of sales because of overvaluation of closing inventory.
Also, it Could be Normal if there is a change in sales Price or Bulk purchase Discount or New market initiatives
 Liquidity ratios:
• Current Ratios = Current Assets ÷ Current Lability
• Quick Ration = (Current Assets – Inventory) ÷ Current Lability
These ratios indicate the ability of a company to meet its short-term debts. Any Abnormal Ratios could be indicator assessing going concern.
if there are indicators of going concern uncertainties, the financial statements must include disclosure and the auditor must evaluate the
adequacy of the disclosures

Efficiency ratios:
• Inventory Holding Period = Inventory ÷ COGS × 365 Days
• Receivable Collection Period = Trade Receivables ÷ Credit Sales × 365 Days
• Payable Payment Period = Trade payables ÷ Credit Purchases × 365 Days
• Inventory Turnover = COGS ÷ Average Inventory (Beginning + Ending ÷ 2)
• Assets Turnover = Revenue ÷ Total Assets
These ratios show how long, on average, companies take to collect cash from customers and pay suppliers and how many days inventory is
held before being sold, Any Abnormal Ratios could be indicator to:
➜ Worsening credit control and increased need for receivables allowance.
➜ Slow-moving and possible obsolete inventory that could be overvalued.
➜ Poor cash flow leading to going concern problems, which would require disclosure

Investor ratios:
• Earning per share = Total Earning ÷ # of Shares
• Gearing = Borrowings ÷ (Share Capital + Reserves)
• Return of Capital Employed (ROCE) = Net Profit before Tax ÷ (Share Capital + Reserves + Borrowings)
These ratios are important for identifying potentially material changes to the statement of financial position (new/repaid loans or share
issues) and for obtaining an overall picture of the annual performance of the business, Any Abnormal Ratios could be indicator to:
➜ A changes in the financing structure of the business
➜ A changes in overall performance of the business.

Materiality
Misstatements are considered to be material if they, individually or in combination, could be influence the economic
decisions of users based on the financial statements.
What is the significance of materiality?
If the financial statements contain material misstatement they cannot be deemed to show a true and fair view.
As a result, the focus of an audit is identifying the significant risks of material misstatement in the financial
statements and then designing procedures aimed at identifying and quantifying them.
How is materiality determined?
The determination of materiality is a matter of Professional judgment. The auditor must consider:
➜ Whether the misstatement would affect the economic decision of the users
➜ Both the SIZE and NATURE of misstatements

Materiality by Size:
establish a financial threshold to guide audit planning and procedures. For this reason the following benchmarks
may be used as a starting point:
½% ⬌ 1% of revenue 5% ⬌ 10% of profit before tax 1% ⬌ 2% of total assets
The above are common benchmarks but different audit firms may use different benchmarks or different thresholds
for each client.

Materiality by Nature:
1) Misstatements that affect compliance with regulatory requirements or debt covenants.
2) Misstatements the adjusted would turn a reported profit into a loss for the year.
3) Misstatements that, when adjusted, would turn a reported net-asset position into a net-liability.
4) Transactions with directors, e.g. salary and benefits, personal use of assets, etc.
5) Disclosures in the financial statements relating to possible future legal claims or going concern issues.

Performance materiality
the auditors won't be able to design tests that identify individual MMs. It is much more common that MM
in aggregate (i.e. several misstatements added together).
For this reason,
The auditor sets performance materiality at a value lower than overall materiality for a whole financial
statements, and uses this lower threshold when designing and performing audit procedures.