Audit Risk & the Auditor’s Response – ACCA AA ( OLD F8 )

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Audit & Assurance exam has a regular question on the Audit Risk & the Response. The examiner may ask you to describe up to 8 Audit Risks along with the Auditor’s response. That means 16 marks in total. It may be less for instance 5 or 6 risks, depending on the marks. A good thing is that this part of the exam can give you absolute marks if attempted with care and appropriate exam approach.

Remember that the most common mistake in this area is that the students write business risk instead of audit risk and struggles a lot in writing Auditor’s response.

Here are the few tips:

  • When writing Audit Risk always relate the risk with financial statements or the accounting treatment. This is simply a risk of incorrect
  • Auditor’s response is the same as Audit Procedure to confirm the assessed

Let’s take some examples to clarify the concept.

Case Study Lines Audit Risk Business Risk Auditor’s Response
Disposal of Non- current Assets by Company Disposed Asset should be removed from the asset register & gain/loss should be recorded in the PorL. There is a risk that asset is still part of PPE and assets may be therefore overstated. In addition, incorrect gain/loss may be

recorded in PorL.

The asset may be disposed less than the Carrying value and results in the Loss on disposal. Profits will be decreased as a result. Auditor should check the NCA register to confirm asset has been removed. Additionally, profit or loss can be recalculated by comparing the disposal proceeds with carrying value.
Receivable is struggling to pay Specific allowance should be created/recorded against the doubtful receivable. Receivables may be overstated if

not provided against.

There is risk that this receivable might not be recovered and resulted in a bad debt. Extended post year- end cash receipts testing should be performed. Discuss with management regarding the inclusion

of allowance.

The financial controller left the company This increases the inherent risk as errors may have been made within the accounting records by the overworked finance

team members.

`The company might struggle to find new financial controller & their financials may be delayed as a result. The audit team should remain alert throughout the audit for additional errors within the finance department.

 

Examples from the real exam Questions

 

Audit Risk & Response
Case study Line Audit Risk Response
The company has invested significantly in production process at the factory. This resulted in expenditure on updating, repairing and replacing a significant amount of the machinery used in the production process. If the expenditure is of a capital nature, it should be capitalised as part of property, plant and equipment (PPE) in line with IAS 16 Property, Plant and Equipment.

However, if it relates more to repairs, then it should be expensed to the statement of profit or loss (income statement). If the expenditure is not correctly classified, profit and PPE could be under or

overstated.

The auditor should review a breakdown of these costs to ascertain the split of capital & revenue expenditure, and further testing should be undertaken to ensure that the classification in the FS is correct.
Disposal of Non-current Assets by Company The asset needs to have been correctly removed from property plant and equipment to ensure the non-current asset register is not overstated, and the profit on disposal should be included within the Statement

of Profit or Loss.

Auditor should check the NCA register to confirm asset has been removed. Additionally, profit or loss can be recalculated by comparing the disposal proceeds with carrying value.
Revaluation of Non-current Assets by Company The revaluation needs to be carried out and recorded in accordance with IAS 16 Property, Plant and Equipment; otherwise non-current assets

may be incorrectly valued.

Review the reasonableness of the valuation & recalculate the revaluation surplus/deficit to ensure that land & buildings are correctly valued.
Unused Property, Plant & Equipment/New production lines and old stopped As per IAS 16 Property, Plant and Equipment and IAS 36 Impairment of Assets, this plant and equipment should be stated at the lower of its carrying value and recoverable amount, which may be at scrap value depending on its age and condition. If this is not the case,

then plant and machinery is overvalued.

Auditor should give special consideration to check for any impairment as per IAS 36.

 

 

Assets life revised impacting reduce depreciation Under IAS 16 Property, Plant and Equipment, useful lives are to be reviewed annually, and if asset lives have genuinely increased, then this change is reasonable. However, there is a risk that this reduction has occurred in order to achieve profit targets. If this is the case, then plant and machinery is overvalued and profit

overstated.

Discuss with the director the rationale for extending useful lives.
A new accounting general ledger has been introduced with the old and new systems being run in parallel. A new accounting general ledger system has been introduced and the old system was run in parallel. There is a risk of opening balances being misstated and loss of data if they have not been transferred

from the old system correctly.

The auditor should undertake detailed testing to confirm that all opening balances have been correctly recorded in the new GL system. They should document & test the new system.
Website has encountered difficulties with recording sales. This could lead to errors in relation to completeness of income. Extended controls testing to be performed over the sales cycle to assess the extent of the errors. Detailed testing to be performed over completeness

of income.

Decreasing/releasing allowance for receivables/receivables struggling to pay/extended the credit limit/receivable days are increased There is a risk that receivables will be overvalued, some balances will be irrecoverable and so will be overstated if not provided against. Extended post year-end cash receipts testing & a review of the aged receivables ledger to be performed to assess valuation & the need for an

allowance for receivables.

Refurbishment Programme This expenditure needs to be reviewed to assess whether it is of a capital nature and should be included within non-current assets or expensed as repairs. There is a risk that expenditure on repairs and maintenance

being capitalized.

Review the breakdown of the costs & agree to invoices to assess the nature of the expenditure &, if capital, agree to the inclusion within the asset register and, if repairs, agree to the SPL.
Development Expenditure incurred/Development is going on This is research and development under IAS 38 Intangible Assets. The standard requires research costs to be

expensed and development

Obtain the breakdown of the expenditure & undertake testing to determine whether the costs relate to the R&D

stage. Discuss the accounting

 

 

costs to be capitalised as an intangible asset if the particular criteria is being met.

If company has incorrectly classified research costs as development expenditure, there is a risk the intangible asset could be overstated and expenses understated.

There is a risk that some projects may not reach final development stage and hence should be expensed rather

than capitalised.

treatment with the FD & ensure it is in accordance with IAS 38.
Damaged/obsolete inventory/slow moving The valuation of inventory as per IAS 2 Inventories should be at the lower of cost and net realisable value. Hence it is likely that this inventory is

overvalued.

Detailed cost & NRV testing to be performed to assess how much the inventory requires writing down.
Inventory count at many warehouses of company It is unlikely that the auditor will be able to attend all inventory counts and therefore they need to ensure that they obtain sufficient evidence over the inventory counting controls, and completeness and existence of inventory for any

warehouses not visited.

The auditor should assess which of the inventory sites they will attend the counts for. For those not visited, the auditor will need to review the level of exceptions noted during the count & discuss with management any issues which

arose during the count.

Standard Costing used for Inventory Valuation

 

 

 

IAS 2 Inventories allows this as an inventory valuation method as long as it is a close approximation to cost. If this is not the case, then inventory could be under or overvalued. There is a risk that the standard costs could be out of date,

resulting in over or undervalued inventory.

The standard costs used for the inventory valuation should be tested in detail and compared to the actual cost. Any significant variations should be discussed with management.
Method of Inventory valuation Inventory should be valued at the lower of cost and net realisable value (NRV) and if this is not the case, then inventory could be under or

overvalued.

Valuation testing should focus on comparing the cost of inventory to the selling price less margin to confirm whether this method is actually a close

approximation to cost.

 

 

Significant levels of work in progress. There is a risk that due to the nature of the production process the audit team may not be sufficiently qualified to assess the quantity and value of work in progress leading to

misstated work in progress.

Consideration should be given as to whether an independent expert is required to value the WIP. If so, this will need to be arranged with consent from management & in time for the

year-end count.

Selling inventory below cost/Substantially low price

 

 

 

 

 

Per IAS 2 Inventories, inventory should be stated at the lower of cost and net realizable value (NRV). There is a risk that the NRV of some inventory items may be lower than cost and hence that inventory could be

overvalued.

Detailed cost & NRV testing to be performed and the aged inventory report to be reviewed to assess whether inventory requires writing down.
Inventory in transit Cut-off of purchases and inventory may not be accurate. At the year end only goods that have been received into the warehouse should be included in the inventory balance and a respective payables balance

recognised.

Physically inspect the inventory to confirm that it has been received before the year end.
Removing or reducing inventory provision/inventory days increased/fall in demand Unless all slow moving/obsolete items are identified at the year end and their value adjusted, there is a risk that the overall value of inventory may be

overstated.

Detailed cost & NRV testing to be performed and the aged inventory report to be reviewed to assess whether inventory requires writing down.
Wrong product sent to customer and customer is claiming damages. Revenue is possibly overstated if the sales returns are not

completely and accurately recorded.

Review the breakdown of sales of damaged goods, and ensure

that they have been accurately removed from the revenue.

Poor quality material used resulting increased warranties. If the overall number of people claiming on the warranty is likely to increase, then the warranty provision should possibly be higher. If the directors have not increased the level of the provision, then there is a risk the provision is

understated.

Review the level of the warranty provision in light of the increased level of claims to confirm completeness of the provision.
Management having significant annual bonus based on the

value of year-end total assets.

There is a risk that management might feel under

pressure to overstate the value

Throughout the audit the team will need to be alert to this risk.

They will need to maintain

 

 

of assets through the judgements taken or through the use of releasing provisions. professional skepticism & carefully review judgmental decisions & compare treatment

against prior years.

The financial controller left the company This increases the inherent risk as errors may have been made within the accounting records by the overworked finance team members. The new financial controller may not be sufficiently experienced to produce the financial statements and resolve any

audit issues.

The audit team should remain alert throughout the audit for additional errors within the finance department.
Company borrowed a loan from Bank The loan needs to be correctly split between current and non- current liabilities. If this is not the case then liabilities would be misclassified. The split between current & non-current liabilities & the disclosures for this loan should be reviewed in detail to ensure compliance with relevant

accounting standard.

There are bank covenants attached to the loan, the main one relating to a minimum level of total assets. This could result in the company being in a net current liability position. If the company did not have sufficient cash flow to meet this loan repayment then there could be going concern implications. In addition company may try to overstate their assets in order to maintain minimum level of

assets.

The team should maintain their professional skepticism and be alert to the risk that assets may have been overstated to ensure compliance with covenants.
Audit firm asked to report earlier than planned Reductions will increase detection risk and place additional pressure on the team in obtaining sufficient and appropriate evidence. The timetable should be confirmed with the FD. If it is to be reduced then consideration should be given to performing an interim audit earlier, this would then reduce the pressure

on the final audit.

Cashflow problems and no financing available/or applied for loan but no yet received If does not receive the money in time then it may struggle to pay liabilities and this could result in going concern difficulties. Discuss with management the status of the loan application and if still outstanding whether any other banks have been approached for the loan.

Perform a detailed going

concern review.

 

 

Making large workforce redundant Under IAS 37 Provisions, Contingent Liabilities and Contingent Assets a redundancy provision will be required for any staff not yet paid at the year end. If this is not the case profits are overstated and

liabilities are understated.

Discuss with management the status of the redundancy programme and review & recalculate the redundancy provision.
Management is under pressure due to previous year poor results There is a risk that management might feel under pressure to manipulate the results through the judgements taken or through the use of provisions. Throughout the audit the team will need to be alert to this risk. They will need to carefully review the judgmental decisions and compare treatment against

prior years.

Growth of revenue is not in line with cost of sales There is a risk that sales may be overstated. During the audit a detailed breakdown of sales will be obtained, discussed with management and tested in order to understand the sales

increase.

The current and quick ratios have decreased Could be evidence of overtrading which could result in going concern difficulties. Detailed going concern testing to be performed during the audit and discussed with the directors to ensure that the going concern basis is

reasonable.

New Audit Client There is a risk that auditor may not able to detect material misstatement due to poor understanding; also opening balances may be materiality misstated as they are unaudited or not audited by new auditor Audit firm should ensure they have a suitably experienced team. In addition, adequate time should be allocated for team members to obtain an understanding of the company and the risks of material misstatement including a detailed team briefing to cover

the key areas of risk.

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