Non-manufacturing costs

Meaning

Costs outside the factory, i.e. selling, distribution, and administration. These are period costs and are not included in the cost of inventory.

Typical examples:

Selling and distribution costs

1. Sales commission for sales staff.
2. Advertising and promotion expenses.
3. Delivery/transportation of finished goods to customers.

Administrative costs

1. Office staff salaries (e.g. HR, accounts, admin).
2. Office rent, office utilities, telephone, stationery at head office.

Manufacturing overhead costs

Meaning

All indirect costs related to the factory/production that are not direct materials or direct labour. Still part of product cost, but cannot be traced easily per unit.

Typical examples:

Indirect factory costs

1. Factory rent or factory building depreciation.
2. Factory electricity, water, and utilities.

Indirect labour and materials in the factory

1. Salary of factory supervisor or maintenance staff.
2. Indirect materials like lubricants, cleaning supplies, screws, glue, etc. used in production but not worth tracing per unit.

Prime costs

Meaning

Prime cost = Direct Materials + Direct Labour

These are costs that can be directly traced to each unit of product.

Typical examples for a manufacturer:

Direct materials – e.g. main raw materials used in production

Example: Wood, steel, fabric, or main components used to make the product.

Direct labour – wages of workers who physically convert materials into finished goods

Example: Wages of machine operators, assembly line workers who work directly on the product.

Differences between management accounting and financial accounting

Aspect	Management Accounting	Financial Accounting
Report frequency / timing	Prepared as often as needed (daily, weekly, monthly, by project, ad hoc). Often uses future-oriented and real-time information for planning and control.	Prepared periodically according to reporting cycles (usually quarterly and annually). Mainly historical information based on past transactions.
User orientation	Aimed at internal users: managers at all levels, department heads, project leaders, budget committees, etc. Focus is on helping decision making, planning, controlling, and performance evaluation inside the organisation.	Aimed at external users: shareholders, investors, lenders, regulators, tax authorities, and sometimes the public. Focus is on providing a true and fair view of financial position and performance of the whole entity.

 

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Comparing traditional vs ABC

Product costs from a traditional absorption system (using only one volume base like machine hours or labour hours) can be less accurate than ABC for several reasons:

1. Not all overheads are driven by volume

• Traditional costing assumes most overheads change with units, labour hours or machine hours.
• In reality, many overheads are driven by activities (set-ups, inspections, order processing, material handling), not just volume. ABC captures this; traditional costing does not.

2. Complex / low-volume products get mis-costed

• A low-volume product that needs many set-ups, design changes, or special handling may use more support resources but not many machine hours.
• Traditional costing will under-cost this product because it looks “cheap” on machine hours. ABC will load more overhead onto it based on its high activity usage.

3. Simple / high-volume products may be over-costed

• A high-volume, standard product may use many machine hours but very few support activities.
• Traditional costing over-costs it by dumping a big share of overhead on it, while ABC charges it less because it consumes fewer activities.

4. Poor decision-making

Because costs are distorted, managers may:

• Set wrong selling prices,
• Drop profitable products (that appear loss-making under traditional costing), or
• Keep unprofitable products (that appear profitable).

ABC gives a clearer link between the cause (activity) and the effect (overhead cost), so product costs are usually more reliable for decisions.

How creative accounting affects ratio analysis

How creative accounting affects ratio analysis

Ratio analysis assumes that the numbers are fairly presented. If accounting has been “creatively” managed, then the ratios that depend on those numbers are also distorted.

Here’s how it can impact key categories of ratios:

(a) Profitability ratios

Examples: gross profit margin, net profit margin, ROA, ROE, EPS.

If revenue is accelerated or expenses are deferred:

• Profits are overstated → margins, ROA, ROE look stronger than they really are.

If provisions/depreciation are understated:

• Current profit is inflated, future periods may suffer (profit volatility).

Effect: Investors may believe the firm is performing well and growing, when it is actually just manipulating timing of income and expenses.

(b) Liquidity ratios

Examples: current ratio, quick ratio.

If the firm:

• Classifies short-term liabilities as long-term,
• Inflates current assets (e.g. overdue receivables not written down),

Then:

Current ratio and quick ratio can look healthy, even though the firm may struggle to pay its short-term debts.

Effect: Banks and creditors may underestimate short-term cash flow problems.

(c) Gearing / solvency ratios

Examples: debt–equity ratio, debt ratio, interest coverage.

Using off-balance sheet financing or misclassifying liabilities can:

• Understate total debt,
• Overstate equity (if assets are inflated and not impaired).

Interest coverage may look comfortable if profit is overstated.

Effect: Users may think the company has low risk and plenty of borrowing capacity, when in reality it is highly leveraged.

(d) Efficiency (activity) ratios

Examples: inventory turnover, receivables turnover, asset turnover.

If inventories or receivables are not properly written down:

• Inventory turnover may appear reasonable because obsolete stock is not recognised.
• Receivable turnover may look good while many debts are actually uncollectable.

Effect: Management may appear efficient while assets are not being used effectively.

(e) Trend and comparison analysis

Ratio analysis is often used to:

• Compare performance over time (trend analysis), and
• Compare with other firms (cross-sectional analysis).

Creative accounting breaks both:

Trend analysis

• If the company “manages” profit differently each year (e.g. big bath one year, then smooth profits), trends become meaningless.
• Growth in profit or improvement in ratios may reflect changes in accounting methods, not real improvement.

Cross-company comparison

• Different firms use different levels of aggressiveness in estimates and policies.
• A more conservative company may look weaker in ratios than an aggressive company, even though it is ctually healthier.
• This reduces comparability, which is one main objective of accounting standards.

Overall impact on users of ratio analysis

Because ratio analysis is only as good as the underlying data, creative accounting leads to:

• Misleading conclusions about profitability, risk, and performance.

Wrong decisions by:

• Investors (buying/selling shares based on inflated EPS, ROE).
• Lenders (granting loans based on manipulated gearing and liquidity ratios).
• Management (believing targets are met when performance is artificially boosted).

Loss of trust in financial reporting once manipulation is revealed.

So, when using ratio analysis, analysts should always remember:

Ratios are useful tools, but they are not foolproof. 

If accounting numbers are distorted by creative accounting, the ratios will also be distorted.

In short

“Therefore, the usefulness of ratio analysis depends heavily on the reliability and integrity of the underlying financial statements. Creative accounting reduces that reliability, making ratio analysis less accurate and potentially misleading.”

Creative accounting

What is creative accounting?

Creative accounting is an act of using accounting choices, estimates and timing to manipulate reported results and financial position without telling users the full, honest economic story.

Common ways it is done:

1. Revenue recognition tricks

• Recognising revenue earlier than appropriate (e.g. before goods/services are really delivered).
• Using aggressive assumptions for long-term contracts so current year profit looks high.

2. Expense manipulation

• Capitalising costs that should be expensed (e.g. treating ordinary repairs as “assets”) to boost current profit.
• Deferring expenses to future periods (“parking” them under prepayments or intangible assets).
• Understating provisions (e.g. warranty, doubtful debts) so current expenses look lower.

3. Changing estimates and policies

• Extending useful lives of assets → lower depreciation now, higher profit.
• Changing inventory valuation method to improve gross profit.
• Adjusting bad debt percentages to “manage” profit.

4. Off–balance sheet and classification games

• Keeping liabilities off the balance sheet (e.g. certain leases, special purpose entities).
• Classifying liabilities as non-current instead of current to improve liquidity ratios.
• Reclassifying items in the cash flow statement to make “operating cash flow” look stronger.

5. “Big bath” behaviour

Taking huge write-offs in one bad year so future years look very good (cleaning the slate).

All of these may technically comply with standards if disclosed, but they distort the picture that users see.

The limitations of using ratio analysis to evaluate a firm’s performance and financial health

1. Ratios are only as good as the financial statements

• If the financial statements contain errors, are manipulated (“window dressing”), or use aggressive accounting estimates, the ratios will give a misleading picture.
• Example: Delaying expenses or recognising revenue early can make profitability and liquidity ratios look better than they really are.

2. Differences in accounting policies

• Firms may use different accounting methods (e.g. FIFO vs. weighted average, different depreciation methods, different impairment policies).
• These policy choices affect profits, assets and liabilities, making ratios across firms not perfectly comparable.
• International comparisons (IFRS vs local GAAP) make this even more problematic.

3. Historical cost and inflation

Financial statements are usually prepared on a historical cost basis. In periods of high inflation, asset values and expenses may be understated.

This can distort:

• Return on assets (ROA) – assets may be undervalued.
• Profit margins – revenues are at current prices, but expenses may be based on older, lower costs.

4. Lack of qualitative information

Ratios focus on numbers and ignore important qualitative factors, such as:

• Quality and competence of management
• Brand strength and customer loyalty
• Employee skills and morale
• Technological advantage, innovation, and R&D
• Regulatory or political risks

A company may look weak on ratios but have strong strategic prospects (or vice versa).

5. No universal “right” benchmark

A ratio on its own says very little. It must be compared with:

• Past performance (trend analysis)
• Industry averages
• Competitors

Even then, there is no clear “correct” level; judgement is needed. For example, a current ratio of 1.2 might be acceptable in a fast-moving retail business but risky in a capital-intensive industry.

6. Industry and firm differences

• Different industries have very different “normal” ratios (e.g. supermarkets vs. heavy manufacturing vs. banks).
• Even within an industry, firms may have different business models (online vs physical stores) that make direct comparison difficult.
• Using industry averages blindly may lead to wrong conclusions.

7. Short-term, static view

• Ratios are usually based on year-end figures; they provide a snapshot at one point in time.
• They may not reflect seasonal variations or intra-year fluctuations in sales, inventory and cash.
• A firm may look liquid at year-end because it reduced payables just before the reporting date.

8. Past performance may not predict the future

Ratios are backward-looking, based on historical data.

They may not capture:

• Upcoming new products or contracts
• Changes in technology or consumer preferences
• Future economic downturns or interest rate changes

A company with strong past ratios could still face serious future problems.

9. Difficulty in interpreting composite effects

One ratio can improve while another worsens. For example:

Profit margin falls but asset turnover rises → what happens to ROA overall?

Ratios are inter-related; focusing on a single ratio without understanding its relationship to others can be misleading.

Different analysts may interpret the same set of ratios differently.

10. Impact of one-off or exceptional items

• Non-recurring items (e.g. gain on disposal of a building, restructuring expenses, impairment losses) can significantly affect profitability ratios.
• If these are not adjusted out, the ratios may not reflect the firm’s underlying, sustainable performance.

11. Ignoring cash flow reality

• Many commonly used ratios are based on accrual accounting, not actual cash flow (e.g. profit margin, ROA, ROE).
• A company may show profit but have poor cash flow, which is more critical for survival.
• Without analysing cash flow ratios (operating cash flow to debt, interest coverage using cash, etc.), the picture is incomplete.

12. Different definitions and calculations

• There is no single standard formula for some ratios (e.g. some use average total assets, others use closing balance; some use EBIT, some use net profit).
• If the definition is not consistent, comparison across firms or across time may be invalid.

13. Conglomerates / diversified companies

• For companies operating in very different industries (conglomerates), industry averages become less meaningful.
• Group-level ratios may hide serious problems in a particular division or segment.

14. Possibility of ratio “management”

Management may take decisions mainly to improve ratios rather than to create real economic value, such as:

• Cutting R&D or marketing to boost short-term profit margins
• Selling assets to improve ROA
• Delaying necessary maintenance to reduce expenses

This can harm long-term performance even if the ratios look better in the short run.

In short

While ratio analysis is a useful starting point for evaluating performance and financial health, it has significant limitations. 

1. Ratios depend on the quality and comparability of the underlying financial statements, are affected by accounting policies, inflation and one-off items, and provide only a historical and quantitative view. 
2. They must therefore be interpreted with caution, in conjunction with other information such as cash flow analysis, qualitative assessments of management and strategy, and the broader economic and industry context.

Common Exam Tips for Students

1. Always find cost per unit for variable costs.

2. Never multiply fixed costs by units. Fixed costs stay the same.

3. Read the question carefully:

“Prepare a flexible budget for 6,000 and 8,000 units” → do two columns.

4. Show workings clearly:

• Variable cost per unit
• Fixed and variable split for mixed costs.

5. In discussion questions, mention:

• Fair comparison
• Better control
• Helps in decision making and performance evaluation.

How Flexible Budget Helps in Performance Evaluation

When actual output is different from budgeted output:

1. Prepare flexible budget at the actual units.
2. Compare Actual vs Flexible Budget, not Actual vs Original Budget.

This allows us to see:

1. Are costs over or under control?
2. Is the problem due to inefficiency or just different volume?

Flexible Budget vs Fixed (Static) Budget

Simple Example (Numbers Made Easy)

Original budget at 5,000 units:

• Selling price per unit: RM10
• Direct material: RM10,000
• Direct labour: RM7,500
• Fixed overheads: RM8,000

Step 1: Calculate per unit for variable costs

• Sales per unit = RM10
• Direct material per unit = 10,000 ÷ 5,000 = RM2
• Direct labour per unit = 7,500 ÷ 5,000 = RM1.50

Fixed overhead remains RM8,000

Required: Flexible budget at 7,000 units

Sales:

= 7,000 × RM10 = RM70,000

Variable costs:

• Direct material = 7,000 × RM2.00 = RM14,000
• Direct labour = 7,000 × RM1.50 = RM10,500

Fixed costs:

Fixed overheads = RM8,000 (no change)

Flexible Budget at 7,000 units

	RM
Sales	70,000
Less: Costs
Direct material	14,000
Direct labour	10,500
Fixed overheads	8,000
Total cost	32,500
Profit	37,500

Students can see:

• At higher units, sales and variable costs increase,
• But fixed cost stays the same, so profit increases.

Steps to Prepare a Flexible Budget

Step 1: Identify each cost as:

• Variable
• Fixed
• Semi-variable (then split into fixed + variable)

Step 2: Find variable cost per unit

For each variable item:

Example:

Direct material cost = RM15,000 for 5,000 units

RM15,000÷5,000=RM3 per unit

Step 3: Identify total fixed cost

Fixed costs stay the same at all activity levels (within relevant range).

Example:

Rent = RM4,000 per month (fixed)

Depreciation = RM5,000 (fixed)

Total fixed cost = RM4,000 + RM5,000 = RM9,000

Step 4: Prepare the flexible budget for the required activity level

For example, flexible budget at 7,000 units:

1. Sales

Selling price per unit × 7,000

2. Variable costs

Variable cost per unit × 7,000 (for each item)

3. Fixed costs

Same total as original (do not multiply by units)

Calculate:

• Total cost
• Profit = Sales – Total cost

Cost Behaviour in Flexible Budget

To prepare a flexible budget, students must understand cost behaviour:

1. Variable Cost

• Changes in total with activity level.
• Cost per unit is constant.

Example: direct material, direct labour, sales commission.

Total variable cost=Cost per unit×Number of units

2. Fixed Cost

• Total cost is constant (within relevant range), even if activity changes.
• Cost per unit will change.

Example: factory rent, supervisor salary, depreciation.

3. Semi-variable / Mixed Cost

• Has fixed part + variable part.
• Example: electricity, maintenance.
• Need to separate into fixed and variable elements before preparing flexible budget.

Why Do We Need a Flexible Budget?

Because actual activity is usually different from the planned activity.

If we compare:

Actual result at 7,000 units

vs

Original budget at 5,000 units

→ This comparison is not fair.

The flexible budget fixes this problem by adjusting the budget to the same activity level as actual.

Main purposes:

1. To make a fair comparison between actual and budget.
2. To help managers control costs.
3. To show whether differences are due to:

- Change in activity level, or

- Inefficiency / overspending.

What is a Flexible Budget?

A flexible budget is a budget that changes (flexes) according to the actual level of activity (e.g. units produced, units sold, machine hours, labour hours).

Static budget 

= based on one activity level

Flexible budget 

= can be prepared for many activity levels 

(e.g. 5,000 units, 6,000 units, 7,000 units)

Budgeting and Budgetary Control - Flexible Budget

What is a Flexible Budget?

Why Do We Need a Flexible Budget?

Cost Behaviour in Flexible Budget

Steps to Prepare a Flexible Budget

Simple Example (Numbers Made Easy)

Flexible Budget vs Fixed (Static) Budget

How Flexible Budget Helps in Performance Evaluation

The High-Low method

Common Exam Tips for Students

The high–low method

The high–low method is a simple way to split a mixed cost into:

• a fixed cost part, and
• a variable cost per unit part

using only two data points: the highest and lowest activity levels.

1. When do we use it?

In cost accounting, some costs are mixed (semi-variable), e.g.:

• Electricity
• Maintenance
• Factory supervisor overtime, etc.

These costs change with activity, but not in a simple straight way.

We want a cost formula:

Total cost=Fixed cost+(Variable cost per unit×Units)

The high–low method helps us find the fixed and variable portions.

2. Steps of the High–Low Method

Step 1: Choose the highest and lowest activity levels

From your data (several months/periods), identify:

• The period with the highest units (or machine hours, etc.)
• The period with the lowest units

Important: We choose based on activity level, not highest/lowest cost.

Example data:

Month	Units	Total Cost (RM)
Jan	6,000	12,500
Feb	8,000	15,500
Mar	10,000	18,500
Apr	14,000	24,500

High activity: 14,000 units, cost RM24,500

Low activity: 6,000 units, cost RM12,500

Step 2: Calculate variable cost per unit

Variable cost per unit=Units at high level−Units at low levelCost at high level−Cost at low level​

Using the example:

Step 3: Find the fixed cost

Use either high or low point in:

Total cost=Fixed cost+(Variable cost per unit×Units)

Using the high point (14,000 units, RM24,500):

Step 4: Use the formula

Now we can estimate the cost at any activity level, say 12,000 units:

Total cost    = 3,500 + 1.50 (12,000)

                    =3,500+18,000

                    = RM21,500

3. Advantages & Limitations

Advantages

• Very simple and quick.
• Only need two data points.
• Good for a rough estimate (e.g., for exam/teaching, budgeting, quick planning).

Limitations

• Uses only highest and lowest points, ignores all other data.
• If high or low points are abnormal (e.g., one-off event), result may be misleading.
• Assumes a linear (straight-line) relationship between cost and activity.

4. Short definition (for exam)

High–low method is a technique to separate mixed costs into fixed and variable components by using the highest and lowest activity levels, calculating the variable cost per unit from the change in cost over the change in activity, and then determining the fixed cost from the total cost at either activity level.

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Week 7 (17-23 November 2025)

Week 7 (17-23 November 2025)

Audit Planning & Fieldwork Part 3b

1. Lecture Notes 1 - Click here
2. Lecture Notes 2 - Audit Planning & Fieldwork Part 3b
3. Self Test - | ST1 | ST2 | ST3 |

Materials to cover - Click here

Week 6 (10-16 November 2025)

Week 6 (10-16 November 2025)

Audit Planning & Fieldwork Part 3a

1. Lecture Notes 1 - Click here
2. Lecture Notes 2 - Audit Planning & Fieldwork Part 3a 
3. Self Test - | ST1 | ST2 | ST3 |

Materials to cover - Click here

Types of Audit Sampling

Types of Audit Sampling

1. Random Selection

• Each item has an equal chance of being chosen.
• Use random number tables or computer-generated random numbers.
• Advantage: Unbiased, statistically sound.
• Example: Use Excel to generate random numbers, then select invoices with those numbers.

2. Systematic Selection

• Choose items using a fixed interval.
• Example: Population = 1,000 invoices, sample size = 100.
• Sampling interval = 1,000 / 100 = 10.
• Choose a random starting point, say 7, then select 7, 17, 27, 37, …
• Advantage: Easy to use.
• Risk: If there is a pattern in the population that matches the interval, it may bias the sample.

3. Haphazard Selection

• Auditor selects items without any special pattern, but also without using random method.
• Should avoid bias, but still based on human judgment.
• Example: Auditor “picks some invoices” from the file, trying not to make any obvious pattern.
• Not truly random, but often used in practice.
• Risk: Human bias can still enter.

4. Monetary Unit Sampling (MUS)

• Also called probability-proportional-to-size (PPS) sampling.
• Items with larger amounts (RM value) have higher chance of being selected.
• Useful when auditor is more concerned about overstatement (e.g. receivables).
• Example: An invoice of RM 100,000 more likely to be selected than RM 100 invoice.

5. Block Selection

• Auditor selects a block (group) of items that are next to each other.
• Example: Choose invoices 201–250 (a block of 50).
• Easy to do, but not representative if there is a pattern in the records.
• Usually not preferred for final conclusions, but sometimes used for preliminary work.

Reasonable Assurance

Reasonable Assurance

Because auditors use sampling, they provide:

Reasonable assurance, not absolute assurance.

Means: high but not 100% certainty that the financial statements are free from material misstatement.

Reasonable assurance is acceptable in practice, as 100% checking is not practical.

Simple definition

Reasonable assurance is a high, but not absolute, level of assurance that the financial statements are free from material misstatement.

In simple words:

• Auditor gives “high confidence”,
• but not 100% guarantee.

Why not 100%?

Because of:

• Sampling – auditor does not check every single transaction.
• Limitations of internal control – controls can fail, people can collude.
• Use of judgment – estimates, assumptions (e.g. bad debts, provisions).
• Time and cost limits – cannot audit forever.

So, the auditor’s job is to reduce audit risk to a low level, and then give reasonable assurance, not absolute certainty.

Exam-style answer (short)

Reasonable assurance is the level of assurance obtained by the auditor as a result of performing an audit, which is high but not absolute, that the financial statements as a whole are free from material misstatement, whether due to fraud or error.

Criteria - representative samples

Why Do Auditors Use Sampling?

Auditors normally cannot check every single transaction (too many, too costly). So they select a sample and draw conclusions about the whole population.

Criteria – Representative Samples

A sample must be representative, meaning it reflects the characteristics of the whole population.

To be representative:

• Every item in the population should have a chance to be selected.
• Selection should avoid bias (not only choosing “nice-looking” documents).
• Sample size must be large enough to give reasonable confidence.

Relationship between Audit Risk and Sampling

Relationship between Audit Risk and Sampling

First recap:

• Audit risk = risk the auditor gives a wrong opinion on financial statements that are materially misstated.
• Sampling = auditor tests only part of the population (not 100%), then makes a conclusion about the whole.

Because auditors use sampling, there is always a chance that:

• The sample looks okay, but the population actually has material misstatement.
• That chance is part of detection risk → audit risk.

1. Where Sampling Fits in the Audit Risk Model

Audit risk model:

AR = IR × CR × DR

Detection Risk (DR) = risk that audit procedures (including sampling) fail to detect a material misstatement.

When auditors use sampling:

• Sampling risk = risk that the sample is not representative, so auditor reaches wrong conclusion.
• Sampling risk is a component of detection risk.

So:

• Higher sampling risk → higher detection risk → higher audit risk
• Lower sampling risk → lower detection risk → lower audit risk

2. How Audit Risk Affects Sampling

If the auditor wants LOW audit risk, they must reduce detection risk, so they must also reduce sampling risk.

How to reduce sampling risk?

• Increase sample size
• Use better selection methods (e.g. random, systematic)
• Ensure representative samples
• Use appropriate population and clear sampling procedures

So:

Acceptable audit risk LOW

➜ Detection risk LOW

➜ Sampling risk LOW

➜ Bigger / better sample, more careful sampling

Acceptable audit risk HIGHER (still acceptable)

➜ Detection risk can be higher

➜ Sampling risk can be higher

➜ Smaller sample may be enough

If auditor wants…	Effect on DR	Effect on Sampling
Very low audit risk	Must be low	Larger sample, more reliable selection
Can accept higher AR	Can be higher	Smaller sample may be acceptable

Exam-style Short Answer (Model)

You can write something like this in exam:

Audit risk and sampling are closely related through detection risk. When auditors use sampling, there is a sampling risk that the selected sample is not representative and material misstatements in the population are not detected. 

This contributes to detection risk and therefore audit risk. If the auditor wants to keep audit risk low, detection risk and sampling risk must also be reduced, usually by increasing the sample size and using more appropriate sampling methods. 

If a higher audit risk is acceptable, the auditor may use smaller samples.

Relationship between Audit Risk and Audit Evidence

Relationship between Audit Risk and Audit Evidence

• inverse relationship between acceptable audit risk & evidence.
• The lower the level of audit risk to be achieved, the greater amount of evidence is needed
• Inherent risk and control risk however, has direct relationship with audit evidence.

First, short recap:

• Audit risk = risk the auditor gives a wrong opinion on materially misstated financial statements.
• To reduce audit risk, the auditor needs sufficient appropriate audit evidence.

So the relationship is basically:

The lower the acceptable audit risk, the more and better audit evidence the auditor must obtain.

1. Inverse Relationship

If the auditor wants LOW audit risk (very confident in the opinion):

➜ Auditor must collect MORE evidence and HIGHER QUALITY evidence.

• Larger sample size
• More substantive tests
• Use more reliable sources (external confirmations, bank statements, etc.)

If the auditor can accept a slightly HIGHER audit risk (still acceptable):

➜ Auditor may collect LESS evidence.

• Smaller sample size
• Fewer procedures
• More reliance on internal controls

So:

Acceptable audit risk ↓ ⇒ Evidence needed ↑

Acceptable audit risk ↑ ⇒ Evidence needed ↓

2. Link with Detection Risk

Remember:

AR = IR × CR × DR

• Detection Risk (DR) = risk that auditor’s procedures fail to detect a material misstatement.
• More evidence → lower detection risk → lower overall audit risk.
• Less evidence → higher detection risk → higher audit risk.

So, when inherent risk and control risk are high, the auditor:

• Must reduce detection risk
• Therefore must collect more, better-quality evidence.

3. Exam-style Short Answer (You Can Use This)

There is an inverse relationship between acceptable audit risk and the amount of audit evidence required. 

When the auditor wants audit risk to be low, detection risk must also be low, so the auditor must obtain more sufficient and appropriate evidence (for example, larger samples and more reliable procedures). 

If the auditor accepts a higher audit risk, less evidence may be collected. Therefore, the level of acceptable audit risk directly affects the nature, timing and extent of audit evidence.

Relationship between Materiality and Audit Risk

Relationship between Materiality and Audit Risk

• inverse relationship between materiality and the level of audit risk
• If materiality level is lower, audit risk is increased

First, quick recap:

• Materiality = how big / important an error must be before it matters to users of the financial statements.
• Audit risk = the risk that the auditor gives the wrong opinion on financial statements that are materially misstated.

They are linked in planning the audit:

When the auditor changes materiality, it affects audit risk and the amount of audit work needed.

1. Inverse relationship (concept)

For a given level of audit work:

Lower materiality (stricter, more sensitive) →

• Even smaller errors are considered material.
• Higher chance that something “material” is missed.
• So audit risk would be higher if auditor doesn’t increase work.

Higher materiality (less strict) →

• Only bigger errors are material.
• Lower chance that a material error is missed.
• So audit risk would be lower if work stays the same.

Therefore, auditors must adjust their procedures so that final audit risk stays acceptably low.

2. How auditors balance them in practice

In planning, the auditor decides:

• Acceptable audit risk (must be low).
• Materiality level (how big a misstatement is “material”).

Then they design their work:

If they set lower materiality (more strict):

• They must reduce detection risk
• → More evidence, larger samples, more detailed testing
• → To keep audit risk low.

If they set higher materiality (less strict):

• They can accept slightly higher detection risk
• → May need less work, smaller samples
• → But still must keep overall audit risk acceptably low.

3. Simple way to explain in exam

You can write something like:

Materiality and audit risk are closely related in audit planning. Materiality is the size or nature of misstatement that could influence users’ decisions, while audit risk is the risk that the auditor gives an inappropriate opinion on materially misstated financial statements. 

If the auditor sets a lower materiality level, more misstatements will be considered material, so to keep audit risk low the auditor must perform more audit procedures and reduce detection risk. 

If a higher materiality level is used, fewer misstatements are material and the auditor may accept a higher detection risk, but overall audit risk must still be kept at an acceptably low level.

How to Minimise Audit Risk?

How to Minimise Audit Risk?

Auditors cannot make audit risk zero, but they can reduce it to an acceptably low level by:

1. Good Planning

• Understand the business and its environment.
• Identify high-risk areas early (using analytical procedures and risk assessment).

2. Assessing IR and CR Properly

• Evaluate internal controls.
• Decide which areas need more testing.

3. Designing Appropriate Audit Procedures

• More substantive tests for high-risk areas.
• Larger sample size.
• Use tests of controls where appropriate.

4. Using Experienced Staff & Supervision

• Ensure work is reviewed.
• Use experts when dealing with complex areas (e.g. valuations).

5. Professional Skepticism

• Do not simply trust management.
• Always ask: “Does this make sense?”

Other views

1. Plan & delegate the audit with due care
2. Auditors selected are competent to perform the audit
3. Audit fee should be based on the work done
4. Sample selected should represent the population

Audit risk

Audit risk 

Risk that auditor gives inappropriate audit opinion on FS that are materially misstated

Can be directly controlled 

3 components of audit risk:

• Inherent risk
• Control risk
• Detection risk

Auditor’s business risk is not the same as audit risk.

Simple definition

Auditor’s business risk is the risk that the audit firm itself suffers loss or negative consequences because of taking on and performing an audit engagement.

In other words: It is the risk that the auditor’s own business is affected – for example:

• Being sued by clients or third parties
• Reputation damage (name spoiled in the market)
• Loss of fees / not being paid
• Regulatory action (fines, penalties, suspension)
• Losing other clients because of bad publicity

Easy examples

1. The auditor gives an unmodified opinion. Later, the company collapses due to fraud.

• Investors sue the auditor → lawsuit = auditor’s business risk.

2. Client is in a high-risk industry (e.g. crypto, gambling, etc.).

• Association with them may hurt the audit firm’s reputation → business risk.

3. Client delays payment of audit fees or cannot pay.

• Audit firm may not recover its costs → business risk.

Difference vs Audit Risk

	Audit Risk	Auditor’s Business Risk
Focus	Risk of wrong audit opinion	Risk to the audit firm’s own business
Main impact	Financial statements users misled	Auditor suffers loss: money, reputation, legal, regulatory
Formula	AR = IR × CR × DR	No standard formula

Short exam-style answer (you can use this)

Auditor’s business risk is the risk that the audit firm will suffer loss or negative consequences as a result of being associated with a client or performing an audit engagement, for example through litigation, loss of reputation, regulatory sanctions or loss of fees.

Significant Risks

Significant risks = risks that are so important that they need special attention in the audit.

Usually:

• Involve unusual or complex transactions,
• High risk of fraud,
• Subjective estimates with high uncertainty.

Examples:

• Revenue recognition with complicated contracts.
• Large related party transactions.
• Complex financial instruments.

For each significant risk, auditor must:

• Understand relevant controls.
• Design stronger, more focused audit procedures.

Detection Risk (DR)

Detection Risk (DR)

Risk that auditor’s procedures fail to detect a material misstatement.

This is the auditor’s own risk.

Can be reduced by:

• Appropriate planning, direction and supervision during the audit work
• Doing more tests or better procedures.
• Using more experienced staff
• Proper assignment of personnel to the engagement team,
• Application of professional scepticism
• Supervision and review of the audit work performed

Control Risk (CR)

Control Risk (CR)

Risk that a misstatement is not prevented or detected by the company’s internal controls.

Depends on how strong or weak the internal control system is.

Example:

• No segregation of duties → one person can record and approve payments.
• Weak control → high control risk.

Inherent Risk (IR)

Inherent Risk (IR)

• The natural risk that an account will be misstated before considering any controls.
• Depends on the nature of the business and the account.
• Higher when:
• Complex transactions
• Estimations (e.g. allowance for doubtful debts)
• Cash-based businesses, easily stolen

Example: Inventory in a fashion store (risk of obsolete stock) → high inherent risk.