Question

Assume you are engaged to audit XYZ corp. They are a privately held construction company with two shareholders. They are seeking a bank loan of $1,000,000 for expansion. All of their construction projects are of similar nature and are in the state of California. The shareholders place great emphasis on the quality of their financial statements and adherence to ethical business practices. One of the shareholders was a former auditor and places great emphasis on having robust and effective internal controls.

INDICATE YOUR INITIAL PLANNING JUDGMENTS: (Low, Medium, High)

Audit risk (AR)	Inherent risk (IR)	Control risk (CR)	Detection risk (DR)
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Answer 1

ISA 300 Planning an Audit of Financial Statements requires that the planning stage of the audit should be used to establish an overall strategy for the audit, develop an audit plan, and reduce audit risk to an acceptably low level. The standard also requires that: „Auditors should plan the audit work so that the engagement is performed in an effective manner.‟ It is important to clarify what are meant by the terms “overall audit strategy” and “audit plan” as per ISA 300. The overall “audit strategy” describes in general terms how the audit is to be carried out and the “audit plan” details the specific procedures to be carried out to implement the strategy and complete the audit. It is also important for students to understand the precise meaning of the risk terms: “audit risk” and “inherent risk” as both risks influence how the audit is carried out and the costs involved. The auditor will spend quite a bit of time at the early planning stages obtaining information to assess these risks so that “the engagement is performed in an effective manner”. “Audit risk” is the risk that an auditor may give an inappropriate audit opinion on financial statements that are materially misstated. To reduce the audit risk to an acceptably low level means the auditor needs to be more than certain that the financial statements are not materially misstated. This is reiterated by ISA 200, which states, “The auditor should plan and perform the audit to reduce audit risk to an acceptably low level that is consistent with the objective of an audit.” “Inherent Risk” as per ISA 400 is “the susceptibility of an account balance or class of transactions to misstatements that could be material, individually or when aggregated with misstatements in other balances or classes, assuming that there are no related internal controls”.Assessing audit risk and inherent risk is an essential part of audit planning because it determines the quantity and quality of evidence that will need to be gathered and the staff that need to be assigned to the particular audit. If for example there were valuation issues with property inherent risk would then be assessed as high, therefore meaning more evidence would have to be gathered and staff that are more experienced assigned to perform testing on this account.