Audit
Audit tests the risk-based audit process: assessing risk, selecting procedures, gathering evidence, and forming an opinion under International Standards on Auditing.
Risk and assertions
- Audit risk = inherent risk × control risk × detection risk. Detection risk is the auditor's lever and is reduced by more effective or extensive substantive procedures.
- Financial statement assertions include occurrence, completeness, accuracy, cut-off, classification, existence, rights and obligations, and valuation.
- Materiality is often set at 5% of profit before tax for a profit-oriented entity. Performance materiality is set lower to reduce the probability that uncorrected misstatements exceed materiality.
Evidence and procedures
- Evidence must be sufficient in quantity and appropriate in quality. Appropriate evidence is relevant and reliable. External confirmations are generally more reliable than internal records; auditor-generated evidence is more reliable than client-generated evidence.
- Procedures include inspection, observation, inquiry, external confirmation, recalculation, re-performance, and analytical procedures. Inquiry alone is rarely sufficient.
- Tests of controls support a lower assessed control risk; substantive procedures address monetary misstatements.
Worked example
Inherent risk is assessed at 80%, control risk at 50%, and planned detection risk at 25%. Audit risk = 0.8 × 0.5 × 0.25 = 10%. If the firm requires audit risk of no more than 5%, detection risk must fall to 0.05 ÷ (0.8 × 0.5) = 12.5%. Lower detection risk requires more reliable or extensive substantive testing. Reasoning: the risk model links assessed risks to the evidence needed; the auditor cannot change inherent or control risk but can change detection risk.
Reporting
- An unmodified opinion states that the financial statements give a true and fair view. Modifications are qualified, adverse, or a disclaimer, depending on materiality and pervasiveness.
- An emphasis of matter paragraph draws attention to a disclosed matter but does not modify the opinion.
Traps that cost marks
- Claiming that an audit provides absolute assurance.
- Confusing sufficient evidence with appropriate evidence.
- Relying on internal audit without evaluating competence and objectivity.
- Treating a scope limitation as an adverse opinion; it usually leads to a qualified opinion or disclaimer.