The Risk Based Approach To External Audit Accounting Essay


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Out of the various approaches to auditing, risk-based approach is one in which resources are directed to those areas of financial statements which are identified to be more risky as a result of the risk faced by the organization. ISA 315 requires auditors to make risk assessments of material misstatements at the financial statement and assertion levels, based on an appropriate understanding of the entity and its environment, including internal controls (ISA 315).

According to the IAASB Glossary of Terms, audit risk is defined as follows:

'the risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated. Audit risk is a function of material misstatement and detection risk.' (IAASB Glossary of Terms)

The audit risk model breaks audit risk down into the following three components:

Inherent risk

This is the susceptibility of an assertion about a class of transaction, account balance, or disclosure to a misstatement that could be material, either individually or when aggregated with other misstatements, before consideration of any related controls (ISA 200) e.g. where the nature of the item is such as a provision which is an estimate.

Control risk

This is the risk that a misstatement could occur in an assertion about a class of transaction, account balance or disclosure, and that the misstatement could be material, either individually or when aggregated with other misstatements, and will not be prevented or detected and corrected, on a timely basis, by the entity's internal control (ISA 200) e.g. improper arrangements at the warehouse makes the value of inventory susceptible.

Detection risk

This is the risk that the procedures performed by the auditor to reduce audit risk to an acceptably low level will not detect a misstatement that exists and that could be material, either individually or when aggregated with other misstatements. (ISA 200)

In exercising judgement as to which risks are significant risks, the auditor is required to consider the following:

Whether the risk is a risk of fraud.

Whether the risk is related to recent significant economic, accounting or other developments, and therefore requires specific attention.

The complexity of transactions.

Whether the risk involves significant transactions with related parties.

The degree of subjectivity in the measurement of financial information related to the risk, especially those measurements involving a wide range of measurement uncertainty.

Whether the risk involves significant transactions that are outside the normal course of business for the entity, or that otherwise appear to be unusual. (Martyn Jones, 2009)

Risk-based approach has gained popularity over popularity over the years as it generally accepted that this approach significantly contributes in minimizing the possibility of objectives not being met. This is because requires auditors to identify the key day-to-day risks faced by a business, to consider the impact these risks could have on the financial statements, and then to plan their audit procedures accordingly. This way resources are allocated where they are required and auditors can '..avoid both over-auditing and under-auditing and can distribute work more evenly throughout the year' (Grobstein and others, 1985, p29). Besides, focusing on the level of risk the risk-based method helps to evaluate and build value into the financial reporting process and the clients company. The main problem faced by auditors when adopting the risk-based approach is when identifying high-risk areas, auditors must decide what evidence should be required and in how much detail.

2. Referring to the scenario: you are the audit manager considering the figures extracted from audit working papers and Bottlefac plc's management accounts. Suggest substantive tests (which may include appropriate analytical procedures) for each item listed below, stating your reasons, to verify that there are no material omissions or misstatements in the balances and transactions of:


Cash and bank

Trade creditors


Turnover of the company show decrease of 15% (7.5m/50m) from previous years average half-yearly figure. This turnover is also less than the budgeted figure of the first two quarters thus the management may have tried to increase this using creative accounting. Based on this the following substantive procedures should be applied.

Analytical and Substantive Procedure


Review & test client's procedures for accounting for numerical sequence of shipping documents & sales invoices.

to find out whether there are any incidences where goods are shipped but revenue not recorded

Trace a sample of shipping documents (e.g. bill of lading) to their respective sales invoices & to the sales journal.

Test a sample of daily reconciliations between sales invoices to daily sales report.

Compare the dates on sales invoices with the dates of the relevant shipping documents.


(to avoid revenue transactions from being recorded in the wrong period)

Compare the dates on the sales invoices to the dates they were recorded in the sales journal.

Review the client's procedures for granting credit to customers.


(to avoid incidences where goods are shipped for a customer who is a bad credit risk; to avoid shipments at unauthorised prices or on unauthorised terms)

Examine sales orders for evidence of credit approval.

Ensure that all shipping documents are accompanied by authorised sales orders.

Compare prices/terms on sales invoices to authorised price list & terms of trade.



Examine the sales invoice for evidence that client personnel verified mathematical accuracy (look for the initials of the staff who did the verification).


(to ensure that sales transaction is recorded at the correct amount)

Recompute the information on a sample of 5 sales invoices.

Review the sales journal & general ledger for proper classification of accounts.


(to ensure that the sales transaction is properly classified)

Examine sales invoices for proper classification.

Examine the reconciliation of sales invoices to daily sales report.

Posting & summarisation

(to ensure correct posting to sales journal or customer's accounts in the Accounts Receivable subsidiary ledger, and from sales journal to the general ledger)

Examine the reconciliation of entries from sales journal to Accounts Receivable subsidiary ledger.

Review the reconciliation of Accounts Receivable subsidiary ledger to general ledger control account.

Review & test client procedures for mailing & handling complaints related to monthly customer statements.

Cash and Bank

Excessive cash and bank pile up of £5.5m that is an increase of 175% from 31 December 2009 makes this area extremely material and important from the perspective of audit risk. Thus the following procedures are necessary.

Analytical and Substantive Procedure


Request for Standard Letter of Request for Confirmation from Banks.



(that there are no unrecorded assets, liabilities or transactions)

to check the accuracy of the transactions recorded

Obtain the cut-off bank statement.

Tests of bank reconciliation:

Verify that the bank reconciliation is mathematically accurate.

Trace the balance on the beginning balance on the cut-off bank statement to the balance per bank on the bank reconciliation statement.

Trace cheques written before year end & included with the cut-off bank statement to the list of outstanding cheques on the bank reconciliation & to the cash payments journal in the period/s prior to the BS date.

Investigate all significant cheques included on the outstanding cheque list that have not cleared the bank on the cut-off statement.

Trace deposits in transit to the cut-off bank statement.

Account for other reconciling items: bank service charges, bank errors/corrections, direct transfers to the bank account.

Cash receipts:

Count the cash on hand on the last day of the year and subsequently trace to deposits in transit (on the bank reconciliation statement) & the cash book.

Trace deposits in transit (in the bank reconciliation statement) to subsequent period bank statement (cut-off bank statement).


(to check only those transactions which relate to this period)

Cash payments:

Record the last cheque number used on the last day of the year & subsequently trace to the outstanding cheques & the cash payments journal.

Trace outstanding cheques to subsequent period bank statement (cut-off bank statement).

Examine minutes, loan agreements & obtain confirmation for restrictions on the use of cash.


Review financial statements to make sure that:

fixed deposits are disclosed separately from cash at bank

cash restricted to certain uses are adequately disclosed

bank overdrafts are included as current liabilities


Trade Creditors

Companies may try to decrease their debt ratios to easily get additional cash in the form of loans and thus this area has to be significantly verified using following procedures.

Analytical and Substantive Procedure


Compare trade creditors, purchases and payments to prior periods and budgets seeking explanations for unusual items and significant variances.


To check all the transactions are recorded

Review monthly movement of trade creditors in comparison to purchases and payments particularly around the period end.


(to check only those transactions which relate to this period)

Analyses the turnover of trade creditor - ratio of creditors to total operating costs (i.e. not financing and investing activities) - and compare to prior periods and budgets, seeking explanations for unusual items and significant variances.

Analyze the ratio of purchases in the last month of the period to total purchases.

Existence or occurrence

that the recorded transactions occurred and belong in the account

Review the gross profit margin achieved particularly around the period end and compare to prior periods and budgets seeking explanations for unusual items and significant variances.

Review the ratio of individual expense accounts to sales or other appropriate base.

Review invoices recorded after the period end and review subsequent cash payments.


(to check only those transactions which relate to this period)

Enquire whether there are any significant purchases or expenses around the period end. Check that these have been accounted for in the correct period.


To check all the transactions are recorded


(to check only those transactions which relate to this period)

Vouch a sample of goods received notes around the period end to ensure cut off procedures have been correctly applied.


To check all the transactions are recorded


(to check only those transactions which relate to this period)

3. Referring to the scenario: identify and describe the matters that give rise to audit risks associated with Bottlefac plc, which may be the basis of your going concern assessment when forming an opinion on the financial position of the company as of 31 December 2010.

ISA (UK and Ireland) 570 requires the auditor to consider the appropriateness of the directors' use of the going concern assumption in the accounts, and consider whether there are any related material uncertainties that need to be disclosed in the financial statements (ISA 570).

Directors of Bottlefac plc seems pretty confident about the going concern of the company and claim that the company is performing well despite the recent recession. It is possible that they may be blinded by the management and they are not considering all the external factors effecting the company, as in these times of recession, they have to be extra careful that all the information regarding the future is considered when making the assessment of going concern. IAS 1 requires that "management takes into account all available information about the future, which is at least, but is not limited to, twelve months from the balance sheet date." (IAS 1)

The turnover of the company indicates a risk, in contrary to management's assessment, as it both less than the budgeted figure for the first two quarters and also less than the average half-yearly figure from the previous year i.e. £50m (£100 / 2).

The company has made a takeover bid for one of Bottlefac's competitors, the outcome of which is uncertain. It is very important to consider the repercussions of this matter. For example, in case this bid is successful, the company will have to face additional fixed costs and increased working capital requirements. The revenue of the company is already decreasing and the in these economic conditions it will be very difficult for the company to get additional cash through loan.

Problems in the company's recent software upgrade produce a risk at the integrity of the information on which the assessment of going concern is based. The management has to make sure that this error does not affect the accuracy of the information within.

Although, the operating profit margin of the company is increasing as well as the liquidity position as excessive cash is present and the going concern is affected positively, but the management needs to carry out a detailed analysis because of the recent economic condition.

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