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The risk-based approach to

audit: audit judgement

Chapter 5
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By Iain Gray & Stuart Manson ISBN 9781844806782
2008 Cengage Learning

Use with The Audit Process: Principles, Practice and Cases

LEARNING OBJECTIVES
After studying this chapter you should be able to:

Define audit risk and suggest why risk-based approaches


have become more important recently.

Identify the components of audit risk and give practical


explanations.

Identify risk in a number of practical scenarios and show


how auditors approach risk.

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By Iain Gray & Stuart Manson ISBN 9781844806782
2008 Cengage Learning

Use with The Audit Process: Principles, Practice and Cases

LEARNING OBJECTIVES CONTD

Define business risk, and show how business risk


approaches differ from audit risk approaches and whether
they are relevant to the audit of companies of all sizes.

Show how enhanced expectations of corporate


governance have increased business risk.

Explain why business risk approaches by auditors may


widen the audit expectations gap.

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By Iain Gray & Stuart Manson ISBN 9781844806782
2008 Cengage Learning

Use with The Audit Process: Principles, Practice and Cases

LEARNING OBJECTIVES CONTD

Explain why judgement is a vital aspect of accounting and


auditing.

Make the distinction between judgement and compliance


with accounting standards.

Explain the relationship between audit judgement and


audit risk.

Suggest what it is that enables successful judgements to


be made.

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By Iain Gray & Stuart Manson ISBN 9781844806782
2008 Cengage Learning

Use with The Audit Process: Principles, Practice and Cases

KEY POINTS p.167

Audit risk (AR), the risk that auditors may give an


inappropriate audit option, has three components:
(a) Inherent risk;
(b) Control risk; and
(c) Detection risk.

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By Iain Gray & Stuart Manson ISBN 9781844806782
2008 Cengage Learning

Use with The Audit Process: Principles, Practice and Cases

KEY POINTS pp.172173


Two further elements to audit risk are:
(a) engagement risk, arising from (i) competitive
tendering by audit firms; and (ii) inherent risk
factors not known to the potential auditors when
tendering;
(b) independence in fact risk, or the risk that
auditors may fail to report material
misstatements in the financial statements,
detected by their audit procedures).

Use with The Audit Process 4th Edition


By Iain Gray & Stuart Manson ISBN 9781844806782
2008 Cengage Learning

Use with The Audit Process: Principles, Practice and Cases

ACTIVITY 5.1

Recall the definitions of the components of audit


risk that we gave you earlier in this book.

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By Iain Gray & Stuart Manson ISBN 9781844806782
2008 Cengage Learning

Use with The Audit Process: Principles, Practice and Cases

KEY POINTS p.168


Business risk results from significant conditions,
events, circumstances, actions or inactions that
could affect the entitys ability to achieve its
objectives.
Business risk is broader than the risk of material
misstatement of the financial statements.
Business risk may arise from change or
complexity or through a failure to recognize the
need for change.

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By Iain Gray & Stuart Manson ISBN 9781844806782
2008 Cengage Learning

Use with The Audit Process: Principles, Practice and Cases

ACTIVITY 5.2

Read the two definitions above and explain the


differences between audit risk and business risk
and state whether you can see a link between
them and why, giving examples. You should read
paras 30-35 of ISA 315 when doing this activity.

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By Iain Gray & Stuart Manson ISBN 9781844806782
2008 Cengage Learning

Use with The Audit Process: Principles, Practice and Cases

KEY POINTS pp.169170


Examples of risks identified in Appendix 2 include:
(i) Changes in operating environment;
(ii) New personnel;
(iii) New or revamped information systems;
(iv) Rapid growth;
(v) New technology;
(vi) New business models, products or activities;
(vii) Corporate restructurings;
(viii)Expanded foreign operations; and
(ix) New accounting pronouncements.
Use with The Audit Process 4th Edition
By Iain Gray & Stuart Manson ISBN 9781844806782
2008 Cengage Learning

Use with The Audit Process: Principles, Practice and Cases

ACTIVITY 5.3

This appears to be a fairly simple scenario, but


there are a number of risks associated with this
kind of company and we ask you to identify the
business risks, which will include industry and
economic risk factors.

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By Iain Gray & Stuart Manson ISBN 9781844806782
2008 Cengage Learning

Use with The Audit Process: Principles, Practice and Cases

ACTIVITY 5.4

Some industries require significant estimates of


revenues and costs. Give examples and suggest
why the existence of significant estimates would
increase the risks of material misstatement of the
financial statements.

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By Iain Gray & Stuart Manson ISBN 9781844806782
2008 Cengage Learning

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ACTIVITY 5.5

Suggest how the above entity-level factors might


have an impact on individual account balances
and transaction classes at the assertion level in
raespect of those balances and transactions.

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2008 Cengage Learning

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KEY POINTS p.180


The three components of audit risk are related:
audit risk (AR) = inherent risk (IR) control
risk (CR) detection risk (DR).
DR relates to acquiring confidence . If the auditor
needs a low detection risk, more transactions and
balances are tested substantively, and the more
confident the auditor is that all are valid.

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By Iain Gray & Stuart Manson ISBN 9781844806782
2008 Cengage Learning

Use with The Audit Process: Principles, Practice and Cases

KEY POINTS p.181


Auditors decide initially the level of audit risk
acceptable to them. Some auditors assess risk in
qualitative terms low, medium and high but the
principle is clear that if you wish audit risk to be low
and you know that inherent risk and control risk are
both high, detection risk will have to be low.

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By Iain Gray & Stuart Manson ISBN 9781844806782
2008 Cengage Learning

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ACTIVITY 5.6

Can you think of controls that Edengrove Ltd


might introduce to increase the likelihood that the
tenants in the managed properties will pay and
on time?

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By Iain Gray & Stuart Manson ISBN 9781844806782
2008 Cengage Learning

Use with The Audit Process: Principles, Practice and Cases

ACTIVITY 5.7

Explain to your assistant the inherent risks that


may arise for environmental reasons or because
of the nature of the companys transactions and
balances. Suggest appropriate controls to reduce
the impact of inherent risk.

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By Iain Gray & Stuart Manson ISBN 9781844806782
2008 Cengage Learning

Use with The Audit Process: Principles, Practice and Cases

ACTIVITY 5.8

Identify controls present in the shops reducing


control risk and hence mitigating inherent risk.

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By Iain Gray & Stuart Manson ISBN 9781844806782
2008 Cengage Learning

Use with The Audit Process: Principles, Practice and Cases

ACTIVITY 5.9

You will have noted that internal auditors visit the


shops on a surprise basis at least at once
annually.
How do you think that internal audit work may
reduce control risk and detection risk and thereby
aid the external auditor?

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By Iain Gray & Stuart Manson ISBN 9781844806782
2008 Cengage Learning

Use with The Audit Process: Principles, Practice and Cases

ACTIVITY 5.10

Write a note in which you explain the issues


arising from the matters coming to your attention
and suggest audit actions you would take. In
each case, state whether the problem is
significant in terms of the risk of giving an
inappropriate opinion.

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Use with The Audit Process: Principles, Practice and Cases

KEY POINTS p.186

Engagement risk is when incoming auditors have


little in-depth knowledge of new clients.
This is likely to enhance risk, particularly if the
auditor is unaware of management deficiencies
and / or unusual pressures on them.

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By Iain Gray & Stuart Manson ISBN 9781844806782
2008 Cengage Learning

Use with The Audit Process: Principles, Practice and Cases

KEY POINTS p.186 CONT'D


Tendering for audit services has become important
and is accompanied by lower audit fees. This
possibly results in policies to reduce the amount of
audit work carried out.
Another risk factor related to lower audit fees is that
auditors become more reliant on non-audit services,
with a consequent threat to independence.

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By Iain Gray & Stuart Manson ISBN 9781844806782
2008 Cengage Learning

Use with The Audit Process: Principles, Practice and Cases

ACTIVITY 5.11

Business risk may be defined as the risk that


the entity will fail to achieve its objectives. Make
a list of possible business objectives that an
entity might have.

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By Iain Gray & Stuart Manson ISBN 9781844806782
2008 Cengage Learning

Use with The Audit Process: Principles, Practice and Cases

KEY POINTS p.187


Examples of business objectives are:

attaining a certain level of profitability;

maximizing shareholder wealth;

ensuring efficiency and effectiveness of


operations;

meeting a desired market share;

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By Iain Gray & Stuart Manson ISBN 9781844806782
2008 Cengage Learning

Use with The Audit Process: Principles, Practice and Cases

KEY POINTS p.187 CONT'D

giving customer satisfaction;

maintaining a desired level of liquidity;

maintaining reputation;

meeting the challenge of changes;

adherence to accepted principles of corporate


governance.

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2008 Cengage Learning

Use with The Audit Process: Principles, Practice and Cases

ACTIVITY 5.12
Kellie is a rapidly growing company providing
advertising copy to a variety of individuals and
companies. It currently has 10% of the
market but its management has as one of its
objectives to increase this to 20% within
the next two years. Management is of the view
that this will be necessary if its desired level of
profitability is to be maintained and if the
company is to retain and attract high quality staff.

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By Iain Gray & Stuart Manson ISBN 9781844806782
2008 Cengage Learning

Use with The Audit Process: Principles, Practice and Cases

ACTIVITY 5.12 CONT'D


Do you think that the information you have about
the business is of relevance to the auditors who
are required to give an opinion on the companys
financial statements at the end of the current
year?
What are the matters that you would wish to
discuss with management about their declared
objective?
Do you think that you might be able to give
management any helpful advice?

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By Iain Gray & Stuart Manson ISBN 9781844806782
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Use with The Audit Process: Principles, Practice and Cases

KEY POINTS p.190


Business risk assessment is a management
technique.
Objectives may change as circumstances change
so assessment should take place regularly.
The approach has been adapted to allow auditors
to provide business risk assessments as
consultancy exercises to audit clients.

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2008 Cengage Learning

Use with The Audit Process: Principles, Practice and Cases

KEY POINTS p.191


There are similarities between business and
inherent risk approaches:
(a) both use a top-down approach;
(b) factors that increase inherent and control risk
may make it less likely that business objectives
will be obtained;
(c) analysis of both helps auditors to prove that
financial statements give a true and fair view.

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Use with The Audit Process: Principles, Practice and Cases

KEY POINTS p.191CONT'D


Dissimilarities are:
(a) auditors consider inherent risks in relation to the
impact they may have on financial statements,
but the business risk approach considers risks
inhibiting the company in achieving objectives;
(b) business objectives and audit objectives are so
dissimilar that the above factors cannot create a
similarity.

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Use with The Audit Process: Principles, Practice and Cases

KEY POINTS p.192


Benefits of the business risk approach are that it:
(a) improves the basic audit of financial statements
and makes erroneous conclusions less likely;
(b) makes audit more efficient and therefore more
profitable;
(c) expands potential for giving assurance to
management to add value and to create
additional sources of income.

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Use with The Audit Process: Principles, Practice and Cases

KEY POINTS p.192 CONT'D


This leads in turn to:
(d) expanded audit, which has the potential to
contribute to corporate governance
arrangements and disclosures;
(e) a better understanding of a clients business
and its risks, thus reducing auditors
engagement risk.

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By Iain Gray & Stuart Manson ISBN 9781844806782
2008 Cengage Learning

Use with The Audit Process: Principles, Practice and Cases

KEY POINTS p.192 CONT'D

Another potential benefit is


(f) advances in IT have resulted in company
records being inherently more reliable, leaving
more scope for audit effort to be devoted to
higher level assessments.

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By Iain Gray & Stuart Manson ISBN 9781844806782
2008 Cengage Learning

Use with The Audit Process: Principles, Practice and Cases

KEY POINTS pp.192193


Business risk approaches mean much planning
work is performed by experienced staff. But
knowledge about management allows auditors to
form views on the reliability of management and the
control environment, and on analytical evidence.
This may lead to a loss of independence and, by
cutting down on over-auditing in non-risk, to underauditing.

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By Iain Gray & Stuart Manson ISBN 9781844806782
2008 Cengage Learning

Use with The Audit Process: Principles, Practice and Cases

ACTIVITY 5.13

Now that you know what the business risk


approach involves, do you think that it can be
applied in the audit of smaller companies by
small audit firms?

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By Iain Gray & Stuart Manson ISBN 9781844806782
2008 Cengage Learning

Use with The Audit Process: Principles, Practice and Cases

KEY POINTS p.194


Analytical procedures are defined in ISA 520 as:
Evaluations of financial information made by a
study of plausible relationships among both financial
and non-financial data. Analytical procedures also
encompass the investigation of identified
fluctuations and relationships that are inconsistent
with other relevant information or deviate
significantly from predicted amounts.

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By Iain Gray & Stuart Manson ISBN 9781844806782
2008 Cengage Learning

Use with The Audit Process: Principles, Practice and Cases

ACTIVITY 5.14
You are auditing a company and have obtained the
following information in from a variety of sources.

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By Iain Gray & Stuart Manson ISBN 9781844806782
2008 Cengage Learning

Use with The Audit Process: Principles, Practice and Cases

ACTIVITY 5.14 CONT'D


The liquidity ratio is calculated as (current assets
less stock)/current liabilities. This ratio is a measure
of the ability of the company to pay its short-term
liabilities as they fall due. Gearing is calculated as
long-term debt/net assets employed x 100.
Both liquidity and borrowings are factors that need
to be taken into account in assessing risk.

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By Iain Gray & Stuart Manson ISBN 9781844806782
2008 Cengage Learning

Use with The Audit Process: Principles, Practice and Cases

ACTIVITY 5.14 CONT'D


The question is whether the company looks more
of a risk for the auditor in the current year
compared with last year?
How would the information above affect your
planning?
What specific additional information would you seek
as part of your audit procedures?

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By Iain Gray & Stuart Manson ISBN 9781844806782
2008 Cengage Learning

Use with The Audit Process: Principles, Practice and Cases

KEY POINTS p.195


Judgement is one of the enduring principles of
auditing, but it is intangible in nature. The
relationship between judgement and risk is direct,
as judgement is exercised in the context of risk.
In forming judgements the auditor makes initial risk
assessments, but modifies them on the basis of
controls in existence and on the validity of figures
in the accounting records.

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By Iain Gray & Stuart Manson ISBN 9781844806782
2008 Cengage Learning

Use with The Audit Process: Principles, Practice and Cases

ACTIVITY 5.15
Wedel Ltd operates a city-centre restaurant
specializing in fast food. During the audit you
discover that a customer has sued the company
for personal injury caused by food poisoning. The
amount claimed is 100,000, but management has
told you that the company has good defences
against the claim.

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By Iain Gray & Stuart Manson ISBN 9781844806782
2008 Cengage Learning

Use with The Audit Process: Principles, Practice and Cases

ACTIVITY 5.15 CONT'D


You are aware that judgement cannot be exercised
in a vacuum and that you require evidence before
you can make a decision. Describe the evidence
that you think you will require. In doing this, give
consideration to matters that you might have
considered at the planning stage.

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Use with The Audit Process: Principles, Practice and Cases

ACTIVITY 5.16
You have been performing a cut-off test at 31
December 2007 to satisfy yourself that purchases
are recorded in the proper period. You have
compared the pre-numbered goods received notes
(GRNs) with purchase invoices to ensure that the
invoices are recorded in 2007 where the GRN has
been issued up to the end of December.

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By Iain Gray & Stuart Manson ISBN 9781844806782
2008 Cengage Learning

Use with The Audit Process: Principles, Practice and Cases

ACTIVITY 5.16 CONT'D


You judged initially that purchase invoices were
recorded in the proper period. However, you had
written to some creditors to confirm amounts owed
to them at 31 December and some had confirmed
higher amounts owing than had been recorded by
your client.
Do you believe that you, as auditor, are at risk?
How would you exercise professional judgement
in respect of this matter?

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By Iain Gray & Stuart Manson ISBN 9781844806782
2008 Cengage Learning

Use with The Audit Process: Principles, Practice and Cases

KEY POINTS p.198


In managing the audit process there are two basic
related objectives:
(a) being professionally effective;
(b) making a fair profit in performing professional
duties.

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By Iain Gray & Stuart Manson ISBN 9781844806782
2008 Cengage Learning

Use with The Audit Process: Principles, Practice and Cases

KEY POINTS p.198 CONT'D

The starting point for effective management of the


audit process is to create a logical structure within
the firm and to allocate responsibilities to partners,
managers, seniors and assistant auditors, ranging
from overall professional effectiveness to
performing detailed audit work.

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By Iain Gray & Stuart Manson ISBN 9781844806782
2008 Cengage Learning

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Figure 5.2

Schematic diagram of an audit firm

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By Iain Gray & Stuart Manson ISBN 9781844806782
2008 Cengage Learning

Use with The Audit Process: Principles, Practice and Cases

ACTIVITY 5.17

What conclusions do you think can be drawn from


the above?

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2008 Cengage Learning

Use with The Audit Process: Principles, Practice and Cases

KEY POINTS pp.201202


The letter of engagement provides the audit
framework and contains:
(a) responsibilities of directors and auditors;
(b) scope of audit;
(c) other services; and
(d) fees.

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By Iain Gray & Stuart Manson ISBN 9781844806782
2008 Cengage Learning

Use with The Audit Process: Principles, Practice and Cases

ACTIVITY 5.18
Do you think that during the course of discussions
you would be able to form an impression of the
competence and integrity of David Jones and Carol
Henshaw?
What would you be looking for in particular?
What do you think that management would expect
from you?

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By Iain Gray & Stuart Manson ISBN 9781844806782
2008 Cengage Learning

Use with The Audit Process: Principles, Practice and Cases

KEY POINTS p.210


The time and fee budgets are directly dependent
on evaluation of risk, which determines the extent
of substantive procedures.
The most important resource used is the time
of partners and staff of the audit firm. The time
budget is designed to give sufficient time to
reduce audit risk to acceptable levels.

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By Iain Gray & Stuart Manson ISBN 9781844806782
2008 Cengage Learning

Use with The Audit Process: Principles, Practice and Cases

CHAPTER SUMMARY
In this chapter we set the scene for the audit,
introducing you to:
An audit firm, the people who work for it and the
way in which their time is charged;
A risk-based approach to audit;
Definitions of audit and business risk;
Approaches to deal with such risks;

Use with The Audit Process 4th Edition


By Iain Gray & Stuart Manson ISBN 9781844806782
2008 Cengage Learning

Use with The Audit Process: Principles, Practice and Cases

CHAPTER SUMMARY CONTD


The link between risk and judgement;
The importance of analytical procedures as a
tool of risk analysis and an aid to audit
judgement;
The importance of the engagement letter;
The need for an auditor to understand the client
company in terms of its internal and external
environment.

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By Iain Gray & Stuart Manson ISBN 9781844806782
2008 Cengage Learning

Use with The Audit Process: Principles, Practice and Cases

FURTHER READING
Colbert, J.L. (1987) Audit risk: Tracing the
evolution, Accounting Horizons, September, pp.
4957.
Eilifsen, A., Knechel, W. and Wallage, P. (2001)
Application of the business risk audit model: a field
study, Accounting Horizons, 15(3): 193207.
Gwilliam, D. (2003) Audit methodology, risk
management and non-audit services, Centre for
Business Performance Briefing, 05.03, ICAEW.

Use with The Audit Process 4th Edition


By Iain Gray & Stuart Manson ISBN 9781844806782
2008 Cengage Learning

Use with The Audit Process: Principles, Practice and Cases

FURTHER READING CONTD


Lemon, Tatum and Turley (2000) Developments in
the Audit Methodologies of Large Accounting
Firms, APB
Williams, P. (2003) Walking away, Accountancy,
April, pp. 267.
Woolf, E. (2003). Audits: An endangered species,
Accountancy, October p. 91.

Use with The Audit Process 4th Edition


By Iain Gray & Stuart Manson ISBN 9781844806782
2008 Cengage Learning

Use with The Audit Process: Principles, Practice and Cases

FURTHER READING CONTD


ISA 210, Terms of Audit Engagements.
ISA 300, Planning an Audit of Financial
Statements.
ISA 315, Understanding the Entity and Its
Environment and Assessing the Risks of Material
misstatement.
ISA 330, The Auditors Procedures in Response to
Assessed Risks.
ISA 520, Analytical Procedures.

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By Iain Gray & Stuart Manson ISBN 9781844806782
2008 Cengage Learning

Use with The Audit Process: Principles, Practice and Cases