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Audit and Assurance- Audit Risks

Audit and Assurance is a paper in Applied skills level of the ACCA Qualification that tests the understanding and application of auditing standards and other assurance engagements such as Review engagement. This is the first audit paper for many candidates so, it is totally normal to feel the subject matter complicated. However, if one go with the right technique, they can get a pass in this paper.

Today, I am basically focusing on audit risk and auditor’s response question which is tested in almost every sitting.

Audit risk is the risk that the auditor issues an inappropriate audit opinion when the financial statements are materially misstated. This means that if there is material error in financial statements and auditor either leave it or miss it to test hence as a result issue unmodified opinion, for example.

Audit risk comprise of Risk of material misstatements i.e., Inherent and control risk and Detection risk.

Inherent risk arises from the nature of the business and industry. For example, Reliance is a pharma company and hence operate in a very strict regulatory requirements. Hence risk of non-compliance is a inherent risk here because non-compliance lead to fines and penalties and hence provisions as per IAS 37 may be necessary and Reliance may not have provide for.

Control risk arises from weak controls of the company. For example, no proper segregation of duties increases the risk of fraud and hence material misstatement in the financial statements.

Detection risk arises from auditor being unable to detect material misstatement that exist in the financial statements. For example, Shubham Shah and Associates is auditing the NMB Bank for the first time this year having audited the NMB Bank by TR Associates last year. Here, we will not be familiar with the nature of the business and transaction as this is the first time we are auditing this Bank and hence we may not be able to detect material misstatement. So, the importance of rigorous audit planning including having thorough understanding of the business is necessary at the initial planning stage.

Audit risk question require understanding of accounting standards basics because we may not identify risk in financial statements without knowing accounting standards knowledge as financial statements are prepared in accordance with applicable accounting framework. For paper AA, it normally assumes knowledge from Paper Financial accounting.

Please note that auditing standards for paper AA is International standards on Auditing (ISA) and accounting standards is International Financial Reporting Standards (IFRS).

Let’s go straight to the recent question extract from Paper F8 March/June 2018 sample examination.

“During the year, Blackberry Co paid $1•1m to purchase a patent which allows the company the exclusive right for three years to customise their portable music players to gain a competitive advantage in their industry. The $1•1m has been expensed in the current year statement of profit or loss.”

This was a part of audit risk question which was asked in the March/June sitting.

This specific part was given maximum marks of 2 normally 1 for audit risk and 1 for auditor’s response.

First let’s talk about audit risk.

The accounting issue identified here is IAS 38 Intangible assets. How do I know this? You may well remember IAS 38 which says that Purchased intangibles should be recognized as asset in the Statement of financial position as Intangible assets and amortized over their useful life. Additional thing for your knowledge purpose is that Internally developed intangibles cannot be recognized as intangible asset in the Individual entity Statement of financial position because it is normally not possible to measure these items. However, this will appear in the consolidated accounts which is outside the scope of Paper AA.

Now what can be audit risk here ?

They have expensed the patent purchase in the profit or loss which is clearly wrong. So what is risk ? The risk is that Intangible asset understated and profit understated because the whole amount has been expensed in PL hence profit understated and intangibles not recognized hence intangibles understated.

Next stage is how to response to the risk?

Please note that this is the planning stage of audit and hence response do not require detailed procedures. This is just the thing what will you do during testing.

So what will you do during testing this item where risks have been identified? Remember to check every fact in the scenario.

The patent have been purchased for $1.1m for 3 years hence first what should you plan to check during testing this in future? You would check the purchase documentation to see the amount of $1.1m and patent period is 3 years.

Next, management have expensed it in PL. Hence you would first ask the management to explain their logic for expensing and request the management to correct the treatment.

Now I am arranging a full 2 mark gaining answer which is expected in exam.

First explain what is risk – There is a risk that profit and intangibles are understated. – ½ mark.

Explain why this is the risk – IAS 38 says that Purchased intangibles should be recognized as asset in the Statement of financial position as Intangible assets and amortized over their useful life. The whole amount has been expensed in PL hence profit understated and intangibles not recognized hence intangibles understated. – ½ mark

Auditor’s response- Enquire the management to explain their logic for expensing full amount in Profit or loss and request the management to correct the treatment. – 1 mark.

This will award you total of full 2 marks.

The examiner has said in her examiner conference that audit risk tend to be more important topics for Paper AA candidate. She stressed that in audit risk question candidate say what is risk and gain ½ mark but do not explain why it is risk and hence lost their another ½ mark.

Written by a member of CCA Management Team.

© CCA

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