Audit Chap 3

Chapter objectives
 This chapter aims at discussing:

 The need for adequate audit planning
 How client acceptance decisions are made
 How to perform initial audit planning.
 The need for understanding the client’s business and industry
for proper planning
 The purposes of audit documentation.
 How organized audit documentation is prepared.
 The nature of the different types of risks using the audit risk
model, and its implication for assessing the audit risk and
decisions about audit evidence
 The concept of materiality
By: YETNAYET AYELE 1

3.1 Need for Audit planning
 Auditing is a task which involves risk, thus proper planning is
essential.
 Knowledge of client’s business is very important part of
planning; it helps to reduce risk associated with the client.
Benefits of planning engagements:
1.To obtain sufficient appropriate evidence
2. To keep audit costs reasonable
3. To avoid misunderstandings with the client
 Proper planning helps to avoid two extremes: under audit (which
increases auditors risk of legal liability) and over audit (which results in
high cost of audit/inefficency).

The major part of audit planning include
 Preliminary risk assessment and
 Preliminary analytical procedures
Preliminary risk assessment

 This is done to minimize the possibility of not
detecting an error/fraud
 Much of audit planning is used :
 To assess the level of risk which is normal/acceptable
 To exclude any non acceptable risk

The auditing profession has no official standards for
an acceptable level of overall audit risk, except that
it should be “acceptably low”
 Zero risk is certainty,
 A 100 percent risk is complete uncertainty.
 Planning the audit helps to keep the risk with in
acceptable/normal limit
 When auditors prefer lower acceptable audit risk,
it means that they want to be more certain that
the financial statements are not materially
misstated and vise versa.

 Factors indicating that risk is above normal:
 New business area/high technology sector
 Poor accounting system, with little/no internal controls
 Dominance by a single person (no separation of duty)
 Strong possibility of management override
 Problems inherent in the nature of business-eg. Direct
cash payments to the beneficiaries from public fund

 Eight Major Parts of Audit Planning
1. Accept 2. Understand
client and the client’s 3. Assess client's
perform initial business business risk
planning industry
5. Set
4. Perform
Materiality & 6. Understand
Preliminary
Assess Internal Control &
Analytical
Inherent & Assess Control Risk
Procedures
Business Risk
7. Gather
Information to 8. Develop Overall Audit
Assess Fraud Risk Plan & Audit program

I. Preplanning the Audit- it involves the
following four issues:
1. Decision to accept new client or continue
serving an existing
2. Identifying why the client needs an audit.
3.Obtaining an understanding of the client
about the terms of the engagement
4. Developing an overall strategy for the audit,
including engagement staffing and any
required audit specialists

1. Client Acceptance/continuence decision
 is a decision that is made before incurring any significant
costs that cannot be recovered.
 General Information needed
▪ About client's reputation/integrity
▪ Does it complain about auditing procedures, does it tried to cheat auditors etc
-Accepting such clients will be more risky
 About risk factors
Is the client’s business involve high risk (eg a high-
technology sector such as software development, insurance
industry, health etc) -Accepting such clients will be more
risky
…..1. Client Acceptance/continuence decision
 An auditor is unlikely to accept a new client or continue
serving an existing client, if acceptable audit risk is
below the risk threshold the firm is willing to accept.
 Information required about new/prospective client
 Standing in the business community- Source : eg. attorney
 Financial stability (financial strength-financial history, credit
rating), Source : eg. banker
 Relations with its previous CPA firm.
▪ Source : previous audit firm (This firm should obtain
permission from the client to provide information to adhere to
the rule of confidentiality)

 Obtaining information from previous Audit firm
 Auditing standards require the new (successor) auditor to
communicate with the predecessor auditor. (communication is
initiated by the new/successor auditor).
 Though the burden of initiating the communication rests with the
successor auditor, the predecessor auditor is required to respond to
the request for information, with client’s permission.
 Information is usually about: Whether the client lacks integrity,
about the existence of disputes over accounting principles, audit
procedures, or fees.

What if unusual circumstances such as legal problems or disputes
between the client and the predecessor exists? Will complete
information be available?
 The predecessor’s response can be limited to stating that no information will be
provided
What if client will not permit the communication or the predecessor will not
provide a comprehensive response?
 In general, in such unusual cases, it is not advisable to accept the new client
without further investigation and gathering of information eg from local
attorneys, other CPAs, banks, and other businesses.
 Even, a professional investigator may be hired to obtain more information
about the reputation and background of key members of management
especially, when there has been no previous auditor to provide
information
 Major factors considered in deciding to drop/not to drop an
existing client:
 Previous conflicts on issues such as scope of the audit, the type of
opinion to issue, unpaid fees, or other matters
 Client lack of integrity
 Presence of excessive risk
Eg. If regulatory conflict exists between a governmental agency
and a client, which could result in financial failure of the client
and ultimately lawsuits against the CPA firm, the auditor will
decide not to accept engagement even if it is profitable, since the
long-term risk may exceed the short-term benefits of doing the
audit.
 Investigating new clients and reevaluating existing ones is an essential
part of deciding acceptable audit risk.
Result of the New Client Investigation
A potential client operates in a reasonably risky industry, but
its management has a reputation of integrity, and also known
to take aggressive financial risks.
Will the client be accepted?
1. No Acceptance 2. Accept
If the CPA firm decides that acceptable Even if acceptable audit risk is low but
audit risk is extremely low the audit firm will increase the fee
proposed to the client.
Audits with a low acceptable audit risk will normally result in

higher audit costs, which should be reflected in higher audit fees.

2. Identifying Client’s Reasons for Audit
 Knowledge of statement users and their intended
uses of the statements affect the decision on
acceptable audit risk.
 The auditor is likely to accumulate more evidence:
-when the statements are to be used extensively, eg
in the case of publicly held companies, those with
extensive indebtedness, and companies that are to
be sold in the near future.

3. Obtaining an understanding of the client about the terms
of the engagement (This helps avoid misunderstandings)
 A clear understanding of the terms of the engagement should exist
between the client and the CPA firm.
 Auditing standards require that auditors document their
understanding with the client in an engagement letter,
including:
▪ the engagement’s objectives, the responsibilities of the
auditor and management, about assistants to be assigned
for the auditor (data providers), fees, impositions like
deadline for the work, and the engagement’s limitations
(to inform what auditors are not responsible for eg
guaranteeing for complete discovery of fraud).
▪ Links Ch 6\Ch 6 Link 1 Example of engagement letter.docx
4. Develop Overall Audit Strategy
 After understanding the client’s reasons for the audit, the auditor should
develop a preliminary audit strategy.
 This strategy helps the auditor determine the resources required for the
engagement, including engagement staffing.
 The auditor must assign the appropriate staff (skilled, experienced)
to the engagement:
- to meet generally accepted auditing standards and
-to promote audit efficiency
Major decisions in staffing:
1. Should staff continuity exist from year to year?
Advantage of Continuity:
 To maintain familiarity with the technical requirements and
 To have closer interpersonal relations with client personnel
 Inexperienced staff will acquire more experience
2. Another major staffing decision is about the need for
outside specialists, should they be invited/not?
 Decision: understand the nature of business, then call
for outside specialists if no one within the firm is
qualified to evaluate a certain evidence important for
the audit
Auditor’s responsibility:
 To evaluate the specialist’s professional qualifications and
understand the objectives and scope of the specialist’s work.
 To consider the specialist’s relationship to the client,
including circumstances that might impair the specialist’s
objectivity.

II. Understand the Client’s Business and Industry
 A through understanding of the client’s business and
industry is essential to conduct an adequate audit.
 Reasons for Understanding Clients Business &
Industry:
 Many industries have unique accounting requirement
that the auditor must understand to evaluate whether the
client’s F/Ss are in accordance with GAAPs.
 Risks in the industry has an effect on the auditor’s
assessment of acceptable audit risk (client 'acceptance
decision).
 There are inherent risks that are typically common to all
clients in certain industries.
 Understanding Clients Business & Industry
requires the auditors to know about:
1. Industry & External Environment
2. Business Operations & Practices
3. Management & Governance
4. Objectives & Strategies
5. Measurement & Performance

1. Knowledge of Industry & External Environment
 It helps the auditor to identify risks associated with
specific industries –assists client acceptance decision
2. Knowledge of Business Operations & Practices .
How to have it?
-Touring/visiting client facilities and operations
Advantage:
▪ to have better understanding of the operations and meet client's
employees
▪ To assess physical safeguards of assets
▪ To identify unused assets (equipments and inventories)
In general, it enables the auditor to assess inherent risks

…2. Knowledge of Business Operations & Practices
 Knowledge of business operations & practices also helps to
identify related parties
 A related party is an affiliated company, a principal owner
of the client company, or any other party with which the
client deals, where one of the parties can influence the
management or operating policies of the other.
 Accounting standards require the disclosure of related party
transactions (transactions between client & related party)
 Eg sales or purchase transactions between a parent company and
its subsidiary, exchanges of equipment between two companies
owned by the same person, and loans to officers.

 Since a related party transaction is not an arm’s-length
transaction, (a transaction with independent third party), it
may be overvalued/undervalued,
 Thus inherent risk is assumed to be high for related parties
transactions because of the lack of independence between the
parties involved in the transactions, and the opportunities
they may provide to engage in fraudulent financial reporting.
 Because material related party transactions must be disclosed,
all related parties need to be identified and included in the
auditor’s permanent files early in the engagement to enable
all auditors on the team to know them, and to identify
undisclosed related party transactions as they do the audit.
3. Knowledge about Client's Management and Governance
 Assessment of management’s philosophy and
operating style, its ability to identify and respond to
risk, are important since they influence the risk of
material misstatements in the financial statements.
 Information about client’s governance system is
obtained from:
 Corporate bylaws
 Code of ethics
 Minutes of meetings of boards
4. Knowledge about Client Objectives and Strategies
 Knowledge of client objectives and strategies helps the auditor to
assess client business risk and inherent risk in the financial
statements.
Eg product quality can have a significant impact on the financial
statements through lost sales and through warranty and product
liability claims.
 Knowledge of client's objectives and strategies also help the auditor
to know matters for which compliance is checked such as:
 contracts and other legal obligations including long-term notes and bonds
payable, stock options, pension plans, contracts with vendors for future delivery
of supplies, government contracts for completion and delivery of manufactured
products, royalty agreements, union contracts, and leases.

5. Knowledge about Client’s Measurement and
Performance
 Performance indicators include non-financial items such as market
share, sales per employee etc
 Inherent risk of F/S misstatements may increase if the client has set
unreasonable performance measurement system that encourages
aggressive accounting.
Eg: Objective-leading market share of industry
Reward- based on the volume of sales
 This may lead to the recording of sales before they have been earned or
recording sales for nonexistent transactions.
 Thus, auditor is likely to increase assessed inherent risk, increase the
extent of testing for the occurrence transaction-related audit objective for
sales. By: YETNAYET AYELE 25
3. Assess Client’s Business Risk
 Knowledge gained from the understanding of the client’s
business and industry is used to assess client business
risk-the risk that the client will fail to achieve its
objectives.
 Sources of Business Risk: -
 Significant declines in the economy that threaten the client’s
cash flows,
 New technology eroding a client’s competitive advantage, or
 Client’s failure to execute its strategies as well as its competitors.

4. Perform Preliminary Analytical Procedures
 Analytical procedures used in planning are often based on aggregate,
companywide data.
 They are used to gain better understanding of the client’s business and
to assess client business risk, they serve as attention directing tools
 Eg. Comparison of client’s ratios to industry or competitor
benchmarks to provide an indication of the company’s performance.
Computing ratios indicating
 short-term debt paying ability (liquidity)
 ability to meet long-term obligations and preferred dividends ,
 activity and profitability ratios etc.
 Such preliminary tests can reveal unusual changes in ratios compared
to prior years, or to industry averages, and help the auditor identify
areas with increased risk of misstatements that require further
attention during the audit.
An Audit program
 An audit program is a collection of audit procedures for an
audit area or an entire audit (for a component of F/S or entire
F/S), each including sample size, item to choose and the
timing of the sample
 Preparation of an audit program is part of planning an audit.
 It shows the steps in the audit process that helps to achieve the
audit objectives, the work that has to be done
 It is prepared for each component of an audit to guide the
auditor: What procedure to apply, When to apply the
procedure, How to apply and so on
 It is used as a base to assign auditors and also follow up the
work
 It also reduces supervisor’s time spent on guiding new

auditors
k

 Audit documentation/working papers are the connecting link
between the client’s accounting records and the audit report.
 They contain all of the work done by the auditor and provide
justification for the audit report.
 They contain:
 audit procedures applied,
 evidence obtained, and
 conclusions reached by the auditor in the engagement.
 The standard of field work focuses on the accumulation of
evidences and audit documentation/working papers
 Working papers should include all information relevant to express
an opinion on the fairness of financial statements
Auditing Part I By Yetnayet Ayele, AAUSC 2012 29
 Audit files should document:
 Items tested if samples of transactions/balances are
tested
 Significant audit findings or issues,
 Actions taken to address them and the basis for the
conclusions reached
Eg. documenting significant misstatements in
account balance, procedures performed including
adjustments made, and conclusions whether the
account balances affected are fairly stated, and
whether any audit adjustments should be proposed.
Purpose of Audit Documentation
 The overall objective of audit documentation is to aid the auditor in
providing reasonable assurance that an adequate audit was conducted in
accordance with GAAS.
 Working papers assist auditors in several ways:
1. They provide information to plan current audit, (provide a means of
assigning and coordinating audit works )
-most audit works require joint efforts, so working papers coordinates the
efforts of auditors assigned on different areas of the audit
2. They aid seniors, managers, and partners in supervising and
reviewing the work of assistants
-Working papers completed by staff assistants are reviewed at successive levels i.e, by the
senior, by the manger, and finally by the partner
 Reviews at different levels provide assurance that the work of the audit staff is carefully
reviewed and supervised
 After each review is completed, the reviewer sill put signature on the working paper

….. Purpose of Audit Documentation
3. They serve as a base for determining the
proper type of audit report
 Partners (owners of the audit firm) know
that issuing an opinion on financial statement
has some risk, so they want to ascertain that
the working paper contains sufficient
competent evidence that justify the report

….Purpose of Audit Documentation
4. They document the evidences accumulated and results of
tests
 Working papers are means by which auditors can
demonstrate their compliance with the generally accepted
auditing standard for field work, and defend their work when
ordered by regulatory agencies such as courts.
 Thus working papers should document:
 Adequate planning and proper supervision of assistants,
 Proper understanding of internal control system, and
 Gathering of appropriate and sufficient evidences to show that the
audit was properly conducted.

…. Purpose of Audit Documentation
5.They provide a base for planning and conducting
future audits of the client
eg they provide information about the time spent
on each activity, the nature of the client internal
control system,
 In addition they provide information useful:
 To prepare tax returns
 To recommend improvements on the existing internal
control system
 To new auditors on how to prepare and organize
working papers

Who owns Audit file, Audit Firm/client?
 Audit documentation/working papers, including schedules
prepare by the client, are the property of the auditors not of
the client.
 The only time anyone else, including the client, has a legal
right to examine the files is when they are subpoenaed
(demanded) by a court as legal evidence.
 At the completion of the engagement, audit files are
retained with the audit firm for future reference and to
comply with auditing standards related to document
retention.
 Auditors may allow clients to refer to some important data
on the working paper
Confidentiality of Audit files
 Auditors working papers usually contain a considerable
amount of information of a confidential nature.
 Rule 301 of the Code of Professional Conduct, states
‘A member shall not disclose any confidential information
obtained in the course of a professional engagement except
with the consent of the client’.
 Audit files should be kept with care, if it is accessible to all,
there is a risk of alteration by clients employees, leakage of
confidential information to client's employees and also to
outsiders
 Thus audit working papers are highly confidential, must be
safeguarded at all times (eg. keeping in lock)
For how long should auditors keep working papers?
 Auditing standards require that records for audits of
private companies be retained for a minimum of five
years.
 The Sarbanes–Oxley Act requires auditors of public
companies to prepare and maintain audit files and other
information related to any audit report for a period of
not less than seven years.
 The law considers deliberate destruction of audit files
as a crime
I. Permanent File: It contains data of a historical or continuing
nature pertinent to the current audit.
 It typically include the following:
1. Extracts or copies of company documents of continuing
importance such as the articles of incorporation, bylaws, bond
indentures, and contracts. The contracts may include pension
plans, leases, stock options, and so on.
2. Analyses from previous years of accounts that have continuing
importance to the auditor.
eg. Analysis related to long-term debt, stockholders’ equity,
goodwill, and fixed asset accounts.
Keeping such information in the permanent files enables
the auditor to concentrate only on the changes in the
current year’s balance

3. Information related to understanding internal control
and assessing control risk.
 Eg. organization charts, flowcharts, questionnaires, and
other internal control information, including
identification of controls and weaknesses in the
system.
4. The results of analytical procedures from previous years’
audits.
 Eg ratios and percentages computed by the auditor and the
total balance or the balance by month for selected accounts.
 This information helps the auditor to identify if there is
unusual change in current year balance which may require
investigation to check if caused by misstatement
II. The Current File: The current files include all working papers applicable
.
to the year under audit.

 The auditor should keep one set of permanent files and a set of current
files for each year’s audit.
 Current file contains:
1. Audit Program-this file contains procedures that will be used for each
area of audit. A well organized audit program is one indicator of the
quality of audit
2. General Information-this file is used to keep current information such
as:
 Audit planning memos,
 Abstracts or copies of minutes of the board of directors meetings,
 Abstracts of contracts or agreements not included in the permanent files,
 Notes on discussions with the client,
 Supervisors’ review comments, and general conclusions.

…Current file contains
3. Working Trial Balance
 It is a schedule listing the balances of accounts in the general
ledger
 It shows for each account,
 Balance at the beginning,
 Current year balance per client’s record,
 Adjustments if any,
 Reclassifications made and ending balance that will appear in
the financial statement.
 It is the backbone of the entire set of audit working papers; it is
the key schedule that controls and summarizes all supporting
papers Auditing Part I By Yetnayet Ayele, AAUSC 2012 41
4. Lead schedules (grouping sheets/summary
schedules)
These are schedules for combining similar general
ledger accounts, the total of which appears on a
working trial balance as a single amount.
eg. a lead schedule for cash may combine petty cash,
cash at bank deposited at different bank,

5. Adjusting journal entries and reclassification
entries
It contains entries to adjust errors discovered in
accounting records and reclassify items that appear
under incorrect classification in the financial
statements
6. Supporting schedules
Schedules show details of a figure that appear in
financial statements . (eg details of the Trade
creditors Account)
 …Current file contains
The following are different types of schedules prepared to
serve different purposes:
1. Analysis of ledger accounts
It is a schedule designed to show the activities in the GL
accounts (debit and credit amounts recorded in ledger
accounts are properly analyzed and cross-referenced to the
working paper)
2. Trial balance: This type of schedule consists of the details
that make up a year-end balance of a general ledger account.
(eg. A/R subsidiary ledger accounts balance, Repair and
maintenance expense ledger balance etc).
 It is prepared only for accounts that appear on year end
financial statement
…Current file ..schedules
3. Reconciliation of amounts.
 A reconciliation schedule supports a specific balance shown on
the financial statement. It is prepared to show the agreement
between amounts obtained from other source (eg. bank
statement) with amounts shown in client’s record
4. Tests of reasonableness.
A test of reasonableness schedule contains information that
enables the auditor to evaluate whether the client’s balance
appears to include a misstatement (to answer questions
such as is this balance reasonable?)
 Eg auditors test depreciation expense, the provision for federal
income taxes, and the allowance for doubtful accounts using tests
of reasonableness.
 These tests are primarily analytical procedures.

5. Summary of procedures.
It is a schedule that summarizes the results of
a specific audit procedure. It documents:
 The extent of testing,
 The misstatements found, and
 The auditor’s conclusion based on the testing.
Eg. summary of the results of accounts
receivable confirmations and the summary of
inventory observations.
6. Examination of supporting documents
 A number of special-purpose schedules are
designed to show detailed tests performed, eg.
documents examined during tests of controls and
substantive tests of transactions.
 These schedules show no totals, and they do not
tie in to the general ledger because their purpose
is document the tests performed and the results
found.
 Such schedules must state a positive or negative
conclusion about the objective of the test.
7. Informational schedule
. This type of schedule contains information, not audit evidence.
eg. information for tax returns, data such as time budgets and the
client’s working hours, which are helpful in administration of the
engagement.
8. Outside documentation.
This file includes outside documentation gathered by auditors,
such as confirmation replies and copies of client agreements.
 Although not “schedules” in the usual sense, they are indexed
and filed. Audit procedures are indicated on them in the same
manner as on other schedules.

Materiality
 FASB has defined materiality as “the magnitude of an
omission or misstatement of accounting information that,
in the light of surrounding circumstances, makes it
probable that the judgment of a reasonable person relying
on the information would have been changed or influenced
by the omission or misstatement”
 It is a judgment as to the level of overall errors or

misstatements that is likely to influence users of F/S
 There is no universal rule for assessing materiality, only
guidelines and professional judgments are used

Materiality threshold
 It is the maximum tolerable amount by which the financial
statements may be misstated but acceptable
 The higher the threshold, the lower the amount of audit test
 Knowing the materiality threshold helps auditor:
1. At planning stage-to determine the extent of tests needed to obtain
sufficient evidence
2. At reporting stage- to evaluate the significance of errors and
irregularities uncovered by the audit (to decide about the type of
report)
 The auditor is responsible to determine whether F/S are
materially misstated.
 If the auditor determines that there is a material
misstatement, he or she will bring it to the client’s attention
so that a correction can be made
 Factors used in Judging Materiality
 Absolute size, relative size, nature of the item or issue,
circumstances, uncertainty, and cumulative effects
 Some methods for quantifying materiality:
 Eg. 5% to 10% of NI before tax
 ½ to 1% of total assets
 ½ to 1% of total revenue
 1% of total equity
Two approaches in Assignment of Materiality
1. Judging materiality amount in each account separately &
combining them to determine the overall effect (bottoms- up)
2. Judging an overall material amount for the financial statements &
then allocating it to particular accounts (Top-down)

There are five closely related steps in applying
materiality
Step 1.Set preliminary judgment about
materiality
Step 2: Allocate preliminary judgment about
materiality to segment
This is necessary because evidence is
accumulated by segments rather than for the
financial statements as a whole.
▪ Most practitioners allocate materiality to balance sheet
rather than income statement accounts.
Step 3: Estimate total misstatement in the segment
Direct projection of
estimate of misstatement = Net misstatement in the sample x Total recorded
Total sampled population value
 Eg: Assume that in auditing inventory, the auditor found Br 3,500 of net
overstatement amount in a sample of Br 50,000 of the total populations of
Br450,000.
 Estimated misstatement (projection) = 3,500 x 450,000
50,000
31,500
Step 4: Estimate the combined misstatement
Step 5: Compare combined estimate with preliminary or revised
judgment about materiality

Illustration of comparison of estimated total to preliminary judgment about
materiality
Tolerable Direct Sampling
Account Misstatement projection error Total
Cash $4,000 $0 $NA $0
A/R 20,000 12,000 6,000 18,000
Inventory 36,000 31,500 15,750 47,250
Total estimated
misstatement 43,500 16,800 60,300
Preliminary
judgment 50,000
about materiality By: YETNAYET AYELE 54
The Concept of Audit Risk
 Audit risk is the probability that an auditor will give
inappropriate opinion on financial statements
OR
the risk that the auditor may unknowingly fail to
appropriately modify an opinion on financial statements that
are materially misstated.
 The Audit Risk Model is expressed as:
AR = IR x CR x DR
where:AR is Audit Risk; IR is Inherent Risk;
CR is Control Risk and DR is Detection Risk
 The model assumes risk elements to be independet (Client’s
side & Auditor’s side)

 Risk Elements in the Audit Risk Model (Client’s
side):
 Inherent Risk (IR)- is the probability that material
misstatements have occurred in transactions entering the
accounting system used to prepare financial statements,
Or
 the risk that an assertion is susceptible to a material
misstatement, assuming there are no related controls
 In general, inherent risk is a risk that errors will occur because of
the environment in which the system operates

Factors Affecting Inherent Risk
 Nature of the client’s business
 Factors related to misstatements arising from fraudulent
financial reporting
 Susceptibility of assets to misappropriation
 Existence of material related parties transactions
 Other circumstances creating pressure/uncertainity (new
technology, high staff turnover etc)
Factors that help to assess Inherent Risk
-Auditor's knowledge of its clients
-Auditor’s knowledge of its client's operating
environment
-Auditor’s knowledge of each auditable area
 Control Risk (CR)- is the probability that the client's
internal control system will fail to detect material
misstatements.
OR
 the risk that a material misstatement that could occur in an
assertion will not be prevented or detected on a timely basis
by the entity’s internal control
 In sum, control risk is a risk that internal controls will not
prevent or detect errors
 Control risk should not be assessed so low (low control risk
means complete reliance is on controls and no other audit
work is performed).

Factors Affecting Control Risk
 Quality of management and staff
 Quality of internal control system
 Level of supervision
 Level and quality of internal audit coverage in an
organization
Factors that help to assess Control Risk
- Assessing the behavior of management & staff,
their attitude towards control, the internal control
system and the level of internal audit service
- Information about time elapsed since last audit.
 The Audit Risk Model (Auditor’s side)
 Detection Risk (DR)– is the probability that audit procedures will
fail to produce evidence of material misstatement
Or
 It is the risk that the auditor will not detect a material misstatement
that exists in an assertion.
 In sum, it is a risk that audit testing and the review of the F/Ss will
not detect material errors.
Thus: if AR = IR x CR x DR,
Detection Risk(DR)= Audit Risk (AR)
Inherent Risk (IR) x Control Risk (CR)
,

 How to address Detection Risk
 Setting appropriate materiality levels and also testing levels help to address
detection risk
Eg (1) The auditor assigns
-Inherent Risk (IR) as 100% (assume no control)
- Control Risk (CR) as100 % (assume poor internal control system)
- Acceptable Audit risk (AAR) as 5% for inventory & Warehousing Cycle. (the
auditor wants to be 95% sure that audit result for this cycle is correct)
What will be the Planned Detection Risk (PDR)?
If AAR = IR x CR x PDR,
Planned Detection Risk(DR)= Audit Risk (AR)
PDR= 0.05=0.05=5%
1X1
 Note: Both IR,CR are subjectively estimated by the auditor on the basis of
his/her knowledge about various factors affecting these risks

Eg (2) The auditor assigns
- Acceptable Audit risk (AAR) as 5% , the auditor wants to be 95%
sure that opinion is correct
- Inherent Risk (IR) as 50% (based on assessing various factors)
- Control Risk (CR) as 20 % (based on tests of control)
What will be the Planned Detection Risk (PDR)?
If AAR = IR x CR x PDR,
Planned Detection Risk(DR)= Audit Risk (AR)
PDR= 0.05= 0.5= 50%
0.5X0.2

 Relationships between Risks and Decisions about Audit
Evidence
 Risk assessment should be performed by experienced staff
Inherent Risk
 The lower the assessed level of inherent risk, the more the reliable
evidence is needed for the audit
Control Risk
 The lower the assessed level of control risk, the more the extensive
test of control is needed than less tests of control
Detection Risk
 The lower the assessed level of detection risk, the more the
extensive substantive test is needed than less substantive tests
 Higher degree of professional judgment is needed

 Relationships between Risks and Decisions about
Audit Evidence
 Low Acceptable Audit Risk implies the need for more
accuracy; eg AAR 5%, means, the auditor wants to be
95% accurate
 Higher IR and CR results in lower Planned Detection
Risk (PDR)
 ie; If the auditor assess higher IR and CR, it means,
greater level of the audit work is required to lower the
detection risk, so as to achieve the desired level of
audit risk
 Thus, assessing risks as part of audit planning helps audit firm to
determine:
 The amount of evidence that will need to be accumulated, and
 The staff assigned to the engagement.
 Eg. if inherent risk for inventory is high because of complex
valuation issues, more evidence will be accumulated in the audit of
inventory, and more experienced staff will be assigned to perform
testing in this area.
 In general planning is needed since audit is a risky business
Note: auditors provide opinion after gathering and evaluating
information from both directions: Top down ie, understanding the
business and industry, the governance and management systems, the
core business process to develop expectations of financial statements
and from bottom up –testing transactions, account balances, and the
system that records the transactions and resulting account balances
guided by the theory , ‘the whole is the sum of its parts”.

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Chapter objectives

 This chapter aims at discussing:

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Preliminary risk assessment

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Audits with a low acceptable audit risk will normally result in

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to the year under audit.

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 It is a judgment as to the level of overall errors or

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