People do not plan to fail, they fail to plan. Planning is an essential feature of an effective audit. The most effective plan is one that is reduced to writing, outlining the audit approach.

Audit risk is a major consideration in the planning of an audit.

Required:

(a) Define each of the following terms from an audit perspective:

i. Audit risk
ii. Inherent risk
iii. Control risk
iv. Detection risk.

(b) Discuss the importance of assessing risks at the planning stage of an audit.

(c) You are the audit senior of Audit Services & Co and are planning the audit of Compusave Co for the year ended 30 September 2010. The company assembles computers and has been a client of your firm for two years; your audit manager has already had a planning meeting with the finance director. He has provided you with the following notes of his meeting and financial statement extracts. Compusaves management was disappointed with the 2009 results and so in 2010 undertook a number of ways to improve the operating results. This included the introduction of a generous sales-related bonus scheme for their salesmen and an aggressive advertising campaign. In addition, they have extended the credit period for their customers.

The finance director of Compusave has reviewed the inventory valuation policy and has included additional overheads incurred this year as he considers them to be production related. He is happy with the 2010 results following the changes they have brought to the Company.

Financial statement extracts for year ended 30 September

                                                                              DRAFT      ACTUAL

                                                                               2010          2009

                                                                                Rs m          Rs m

Revenue                                                     23·0          18·0

Cost of Sales                                             (11·0)        (10·0)

Gross profit                                                12·0            8·0

Operating expenses                                     (7·5)          (4·0)

Profit before interest and taxation                     4·5            4·0

Inventory                                                  I 2·1            1·6

Receivables                                                 4·5            3·0

Cash                                                             -            2·3

Trade payables                                            1·6            1·2

Overdraft                                                    0·9                -

Required:

Using the information above:

(i) Determine SIX ratios, for BOTH years, which would assist the audit senior in planning the audit; and

(ii) From a review of the above information and the ratios calculated, Illustrate the audit risks that arise and explain the appropriate response to these risks.