1 Introduction to risk
1.1 Professional scepticism, professional judgement and ethical
requirements
FAST FORWARD
Auditors are required to carry out the audit with an attitude of professional scepticism, exercise
professional judgement and comply with ethical requirements.
Key terms Professional scepticism is an attitude that includes a questioning mind, being alert to conditions which
may indicate possible misstatement due to error or fraud, and a critical assessment of audit evidence.
Professional judgement is the application of relevant training, knowledge and experience in making
informed decisions about the courses of action that are appropriate in the circumstances of the audit
engagement.
1.1.1 Professional scepticism
ISA 200 Overall objectives of the independent auditor and the conduct of an audit in accordance with
International Standards on Auditing states that auditors must plan and perform an audit with an attitude of
professional scepticism recognising that circumstances may exist that cause the financial statements to
be materially misstated.
This requires the auditor to be alert to:
x Audit evidence that contradicts other audit evidence obtained
x Information that brings into question the reliability of documents and responses to inquiries to be
used as audit evidence
x Conditions that may indicate possible fraud
x Circumstances that suggest the need for audit procedures in addition to those required by ISAs
Professional scepticism needs to be maintained throughout the audit to reduce the risks of overlooking
unusual transactions, over-generalising when drawing conclusions, and using inappropriate assumptions
in determining the nature, timing and extent of audit procedures and evaluating the results of them.
Professional scepticism is also 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.
1.1.2 Professional judgement
ISA 200 also requires the auditor to exercise professional judgement in planning and performing an audit
of financial statements. Professional judgement is required in the following areas:
x Materiality and audit risk
x Nature, timing and extent of audit procedures
x Evaluation of whether sufficient appropriate audit evidence has been obtained
x Evaluating management’s judgements in applying the applicable financial reporting framework
x Drawing conclusions based on the audit evidence obtained
1.1.3 Ethical requirements
ISA 200 states that the auditor must comply with the relevant ethical requirements, including those
relating to independence, that are relevant to financial statement audit engagements. We discussed
professional ethics in Chapter 4 of this Study Text.
Part C Planning and risk assessment ~ 6: Risk assessment 95
, 1.2 Overall audit risk
Auditors usually follow a risk-based approach to auditing as required by ISAs. In this approach, auditors
analyse the risks associated with the client's business, transactions and systems which could lead to
misstatements in the financial statements, and direct their testing to risky areas. This is in contrast to a
procedural approach which is not in accordance with ISAs. In a procedural approach, the auditor would
perform a set of standard tests regardless of the client and its business. The risk of the auditor providing an
incorrect opinion on the truth and fairness of the financial statements might be higher if a procedural
approach was adopted.
1.3 Audit risk Dec 08
FAST FORWARD
Audit risk is the risk that the auditor expresses an inappropriate audit opinion when the financial
statements are materially misstated. It is a function of the risk of material misstatement (inherent risk and
control risk) and the risk that the auditor will not detect such misstatement (detection risk).
Key term Audit risk is the risk that the auditor expresses an inappropriate audit opinion when the financial
statements are materially misstated.
Audit risk has two elements, the risk that the financial statements contain a material misstatement and the
risk that the auditors will fail to detect any material misstatements.
Audit risk has two major components. One is dependent on the entity, and is the risk of material
misstatement arising in the financial statements (inherent risk and control risk). The other is dependent on
the auditor, and is the risk that the auditor will not detect material misstatements in the financial statements
(detection risk). We shall look in detail at the concept of materiality in the next section of this chapter. Audit
risk can be represented by the audit risk model:
Audit risk = Inherent risk u control risk u detection risk
1.3.1 Inherent risk
Key term Inherent risk is the susceptibility of an assertion to a misstatement that could be material individually or
when aggregated with other misstatements, assuming there were no related internal controls.
Inherent risk is the risk that items will be misstated due to the characteristics of those items, such as the
fact they are estimates or that they are important items in the accounts. The auditors must use their
professional judgement and all available knowledge to assess inherent risk. If no such information or
knowledge is available then the inherent risk is high.
Inherent risk is affected by the nature of the entity; for example, the industry it is in and the regulations it
falls under, and also the nature of the strategies it adopts. We shall look at more examples of inherent
risks later in this chapter.
1.3.2 Control risk
The other element of the risk of material misstatements in the financial statements is control risk.
Key term Control risk is the risk that a material misstatement that could occur in an assertion and that could be
material, 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.
We shall look at control risk in more detail in Chapter 9 when we discuss internal controls.
96 6: Risk assessment ~ Part C Planning and risk assessment
1.1 Professional scepticism, professional judgement and ethical
requirements
FAST FORWARD
Auditors are required to carry out the audit with an attitude of professional scepticism, exercise
professional judgement and comply with ethical requirements.
Key terms Professional scepticism is an attitude that includes a questioning mind, being alert to conditions which
may indicate possible misstatement due to error or fraud, and a critical assessment of audit evidence.
Professional judgement is the application of relevant training, knowledge and experience in making
informed decisions about the courses of action that are appropriate in the circumstances of the audit
engagement.
1.1.1 Professional scepticism
ISA 200 Overall objectives of the independent auditor and the conduct of an audit in accordance with
International Standards on Auditing states that auditors must plan and perform an audit with an attitude of
professional scepticism recognising that circumstances may exist that cause the financial statements to
be materially misstated.
This requires the auditor to be alert to:
x Audit evidence that contradicts other audit evidence obtained
x Information that brings into question the reliability of documents and responses to inquiries to be
used as audit evidence
x Conditions that may indicate possible fraud
x Circumstances that suggest the need for audit procedures in addition to those required by ISAs
Professional scepticism needs to be maintained throughout the audit to reduce the risks of overlooking
unusual transactions, over-generalising when drawing conclusions, and using inappropriate assumptions
in determining the nature, timing and extent of audit procedures and evaluating the results of them.
Professional scepticism is also 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.
1.1.2 Professional judgement
ISA 200 also requires the auditor to exercise professional judgement in planning and performing an audit
of financial statements. Professional judgement is required in the following areas:
x Materiality and audit risk
x Nature, timing and extent of audit procedures
x Evaluation of whether sufficient appropriate audit evidence has been obtained
x Evaluating management’s judgements in applying the applicable financial reporting framework
x Drawing conclusions based on the audit evidence obtained
1.1.3 Ethical requirements
ISA 200 states that the auditor must comply with the relevant ethical requirements, including those
relating to independence, that are relevant to financial statement audit engagements. We discussed
professional ethics in Chapter 4 of this Study Text.
Part C Planning and risk assessment ~ 6: Risk assessment 95
, 1.2 Overall audit risk
Auditors usually follow a risk-based approach to auditing as required by ISAs. In this approach, auditors
analyse the risks associated with the client's business, transactions and systems which could lead to
misstatements in the financial statements, and direct their testing to risky areas. This is in contrast to a
procedural approach which is not in accordance with ISAs. In a procedural approach, the auditor would
perform a set of standard tests regardless of the client and its business. The risk of the auditor providing an
incorrect opinion on the truth and fairness of the financial statements might be higher if a procedural
approach was adopted.
1.3 Audit risk Dec 08
FAST FORWARD
Audit risk is the risk that the auditor expresses an inappropriate audit opinion when the financial
statements are materially misstated. It is a function of the risk of material misstatement (inherent risk and
control risk) and the risk that the auditor will not detect such misstatement (detection risk).
Key term Audit risk is the risk that the auditor expresses an inappropriate audit opinion when the financial
statements are materially misstated.
Audit risk has two elements, the risk that the financial statements contain a material misstatement and the
risk that the auditors will fail to detect any material misstatements.
Audit risk has two major components. One is dependent on the entity, and is the risk of material
misstatement arising in the financial statements (inherent risk and control risk). The other is dependent on
the auditor, and is the risk that the auditor will not detect material misstatements in the financial statements
(detection risk). We shall look in detail at the concept of materiality in the next section of this chapter. Audit
risk can be represented by the audit risk model:
Audit risk = Inherent risk u control risk u detection risk
1.3.1 Inherent risk
Key term Inherent risk is the susceptibility of an assertion to a misstatement that could be material individually or
when aggregated with other misstatements, assuming there were no related internal controls.
Inherent risk is the risk that items will be misstated due to the characteristics of those items, such as the
fact they are estimates or that they are important items in the accounts. The auditors must use their
professional judgement and all available knowledge to assess inherent risk. If no such information or
knowledge is available then the inherent risk is high.
Inherent risk is affected by the nature of the entity; for example, the industry it is in and the regulations it
falls under, and also the nature of the strategies it adopts. We shall look at more examples of inherent
risks later in this chapter.
1.3.2 Control risk
The other element of the risk of material misstatements in the financial statements is control risk.
Key term Control risk is the risk that a material misstatement that could occur in an assertion and that could be
material, 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.
We shall look at control risk in more detail in Chapter 9 when we discuss internal controls.
96 6: Risk assessment ~ Part C Planning and risk assessment
