Define audit risk and the components of audit risk.

(4 marks) June 2016, Mar-June 2017

Audit risk is the risk that the auditor expresses an inappropriate audit opinion when the financial
statements are materially misstated. Audit risk is a function of two main components, being the risk of
material misstatement and detection risk. Risk of material misstatement is made up of a further two
components, inherent risk and control risk.

Inherent risk is the susceptibility of an assertion about a class of transaction, account balance or
disclosure to a misstatement which could be material, either individually or when aggregated with other
misstatements, before consideration of any related controls.

Control risk is the risk that a misstatement which could occur in an assertion about a class of
transaction, account balance or disclosure and which could be material, either individually or when
aggregated with other misstatements, will not be prevented, or detected and corrected, on a timely
basis by the entity’s internal control.

Detection risk is the risk that the procedures performed by the auditor to reduce audit risk to an
acceptably low level will not detect a misstatement which exists and which could be material, either
individually or when aggregated with other misstatements. Detection risk is affected by sampling and
non-sampling risk.

Explain what is meant by 'professional scepticism' and why it is so important that the auditor
maintains professional scepticism throughout the audit. (3 marks) mock examination

Professional Scepticism

Professional scepticism is an attitude that includes having a questioning mind, being alert to conditions
which may indicate possible misstatement due to error or fraud, and subjecting audit evidence to a
critical assessment rather than just taking it at face value (ISA 200). It is important that professional
scepticism is maintained throughout the audit to reduce the risks of overlooking unusual transactions, of
over generalising when drawing conclusions, and of using inappropriate assumptions in determining the
nature, timing and extent of audit procedures and evaluating the results of them. Professional
scepticism is necessary to the critical assessment of audit evidence. This includes questioning
contradictory audit evidence and the reliability of documents and responses from management and
those charged with governance.

Define 'professional judgement' and describe TWO areas where professional judgement is applied
when planning an audit of financial statements. (3 marks) mock examination

Professional judgement

Professional judgement is the application of relevant training, knowledge and experience in making
informed decisions about the appropriate courses of action in the circumstances of the audit
engagement. The auditor must exercise professional judgement when planning an audit of financial
statements (ISA 200). Professional judgement will be required in many areas when planning. For
example, the determination of materiality for the financial statements as a whole and performance
materiality levels will require professional judgement. Professional judgement will also be required
when deciding on the nature, timing and extent of audit procedures.

Identify THREE aspects in respect of which auditors would be expected to exercise their professional
judgement, when auditing the financial statements of a company operating a hotel chain. (6 marks)
June 2020

Professional Judgement

An auditor may be expected to exercise their professional judgement in such a situation on a very broad
range and high volume of aspects including:

• In determining materiality at the planning stage for the financial statements as a whole, and also that
set at a lower level or levels for particular classes of transactions, account balances or disclosures
(performance materiality).

• In assessing inherent risk, control risk and determining acceptable levels of detection risk in the
various areas of the financial statements.

• In deciding on the nature, timing and extent of substantive procedures to carry out in the area of room
hire, to reduce audit risk to an acceptable level.

• In selecting appropriate members of the audit team to carry out testing and in the delegation of
specific responsibilities and duties to them.

• In selecting the hotels to be visited to carry out tests and the tests to carry out.

• In evaluating the reasonableness of the company’s depreciation policies and rates pertaining to its
various categories of non-current assets.

• In determining the extent of use of computer-assisted audit techniques to obtain audit evidence. In
evaluating management’s judgements in applying the applicable financial reporting framework. • In
determining the type of audit opinion to be expressed in the auditor’s report.

Define and explain materiality and performance materiality. (4 marks) Mar-June 2019

Materiality and performance materiality are dealt with under ISA 320 Materiality in Planning and
Performing an Audit. Auditors need to establish the materiality level for the financial statements as a
whole, as well as assess performance materiality levels, which are lower than the overall materiality for
the financial statements as a whole.

Materiality

Materiality is defined in ISA 320 as follows: “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.”
If the financial statements include a material misstatement, then they will not present fairly (give a true
and fair view) the position, performance and cash flows of the entity.

A misstatement may be considered material due to its size (quantitative) and/or due to its nature
(qualitative) or a combination of both. The quantitative nature of a misstatement refers to its relative
size. A misstatement which is material due to its nature refers to an amount which might be low in value
but due to its prominence and relevance could influence the user’s decision, for example, directors’
transactions.

As per ISA 320, materiality is often calculated using benchmarks such as 5% of profit before tax or 1% of
total revenue or total assets. These values are useful as a starting point for assessing materiality,
however, the assessment of what is material is ultimately a matter of the auditor9s professional
judgement. It is affected by the auditor’s perception of the financial information, the needs of the users
of the financial statements and the perceived level of risk; the higher the risk, the lower the level of
overall materiality.

In assessing materiality, the auditor must consider that a number of errors each with a low value may,
when aggregated, amount to a material misstatement.

Performance Materiality

Performance materiality is defined in ISA 320 as follows: “The amount 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.”

Hence performance materiality is set at a level lower than overall materiality for the financial
statements as a whole. It is used for testing individual transactions, account balances and disclosures.
The aim of performance materiality is to reduce the risk that the total of all of the errors in balances,
transactions and disclosures exceeds overall materiality.