Chapter 4 - Risk Assessment Procedures

PLANNING THE AUDIT:
IDENTIFYING AND RESPONDING

TO THE RISKS OF MATERIAL
MISSTATEMENT
LEARNING OBJECTIVES
1. Describe the concept of material misstatement and
apply a process for making materiality assessments
2. Identify the risks of material misstatement and describe
how they relate to audit risk and detection risk
3. Assess factors affecting inherent risk, including fraud
risk factors
4. Assess factors affecting control risk
5. Use planning analytical procedures to identify areas of
heightened risk of material misstatement
7-2
Copyright © 2016 South-Western/Cengage Learning
LEARNING OBJECTIVES
7. Describe how auditors make decisions about

detection risk and audit risk
8. Respond to the assessed risks of material
misstatement and plan the procedures to be
performed on an audit engagement
7-3
THE AUDIT OPINION FORMULATION
PROCESS
7-4
LEARNING OBJECTIVE 1
DESCRIBE THE CONCEPT OF MATERIAL MISSTATEMENT

AND APPLY A PROCESS FOR MAKING MATERIALITY
ASSESSMENTS
WHAT IS A MISSTATEMENT
• Misstatement: An error, either intentional or
unintentional, that exists in a transaction or financial
statement account balance
• Essential to understand materiality in the context of
designing and conducting a quality audit
• Auditors are concerned about material
misstatements
7-6
MATERIALITY JUDGMENTS
• (1) are a matter of professional judgment

• (2) depend on the needs of a reasonable
person relying on the information (an investor,
potential investor, or other stakeholder)
• (3) involve both quantitative and qualitative
considerations
7-7
DEFINING MATERIALITY
7-8
DEFINING MATERIALITY
7-9
A PROCESS FOR MAKING MATERIALITY
ASSESSMENTS
• Consider a client where financial statement
materiality is set at $150,000 and materiality for the
accounts receivable balance is set at $110,000.
• The performance materiality for auditing accounts
receivable might then be set at $30,000.
• This approach compensates for the possibility that
multiple undetected or uncorrected misstatements in
the accounts receivable balance might exist.
7-10
PROCESS FOR MAKING MATERIALITY
ASSESSMENTS
• The auditor will aggregate identified misstatements
so the audit team can assess the materiality of these
misstatements
• The document where misstatements are aggregated
is often referred to as a summary of unadjusted audit
differences (SUAD)
• Clearly trivial amount (posting materiality)
• Inconsequential, whether:
• Taken individually or in the aggregate
• Judged by any criteria of size, nature, or circumstances
7-11
QUALITATIVE CONSIDERATIONS
• Auditors consider both quantitative effects (such as the
dollar magnitude of a misstatement) and qualitative effects (such
as the reason for the misstatement)
• Qualitative reasons for considering quantitatively
small misstatement material
• Hiding failure to meet analysts’ consensus expectations
• Changing a loss into income, or vice versa
• Affecting compliance with loan covenants
• Effecting the increases in management’s compensation
7-12
IDENTIFY THE RISKS OF
MATERIAL MISSTATEMENT
AND DESCRIBE HOW THEY
RELATE TO AUDIT RISK AND
DETECTION RISK
RISK DEFINITIONS
7-14
RISK DEFINITIONS
7-15
DETECTION RISK
• Level of audit effort that auditor will expend on
engagement depends on level of detection risk
Increase in evidence
When risk of material Detection risk is set obtained through
misstatement is higher lower substantive audit
procedures
7-16
ASSESS FACTORS AFFECTING
INHERENT RISK, INCLUDING
FRAUD RISK FACTORS
INHERENT RISK AT THE ACCOUNT / ASSERTION
LEVEL
• Factors indicating a higher level of inherent risk
• Account represents an asset that can be easily stolen
• Account balance made up of complex transactions
• Account balance requires a high level of estimation to
value
• Account balance subject to adjustments that are not in
the ordinary processing routine
• Account balanced composed of a high volume of
nonroutine transactions
7-18
INHERENT RISK AT THE FINANCIAL
STATEMENT LEVEL: BUSINESS RISKS
• Inherent risk at financial statement level that affects
business operations and potential outcomes of
organizational activities
• Examples of factors affecting this risk
• Overall economic climate
• Technological changes
• Competitor actions
• Geographic locations of suppliers
7-19
RISK ASSESSMENT PROCEDURES FOR
ASSESSING BUSINESS RISKS
• Management inquiries • Online searches
• Review of client’s budget • Review of SEC filings
• Tour of client’s plant and • Company Web sites
operations • Economic statistics
• Review government
• Professional practice
regulations and client’s
bulletins
legal obligations
• Stock analysts’ reports
• Knowledge management
systems • Company earnings calls
7-20
INHERENT RISK AT THE FINANCIAL STATEMENT
LEVEL: FINANCIAL REPORTING RISKS
• When assessing this risk, auditors consider all items
on a company’s financial statements that are
subjective and based on judgment
• Inherent risk at the financial statement level is affected
by:
• Competence and integrity of management
• Potential incentives to misstate the financial statements
7-21
ASSESSING MANAGEMENT INTEGRITY
• Inquiries
• Predecessor auditor
• Other professionals in business community
• Other auditors within audit firm
• Management
• Audit committee members
• Federal regulatory agencies
• Review
• News media and Web searches
• Public databases
7-22
FACTORS INDICATING A HIGHER LEVEL OF
INHERENT RISK – FINANCIAL REPORTING RISKS
• Discrepancies in accounting • An impending initial
records public offering of stock
• Unusual relationships • Disagreements over
between auditor and financial reporting with
management prior auditors
• Lack of management
• Auditor resignation
competence
• Company history of meeting
• Unusual transactions with
analyst estimates or high outsiders or significant
earnings growth related party transactions
expectations
7-23
ASSESSING FRAUD RISK
• Brainstorming
• A group discussion designed to encourage auditors to
creatively assess client risks, particularly those relevant
to possible existence of fraud
• Occurs during the early planning phases of audit
• Attended by entire engagement team and led by audit
partner or manager
• Other Procedures
• Inquiry
7-24
ASSESS FACTORS AFFECTING
CONTROL RISK
CONTROL RISK
• Relates to susceptibility that a misstatement will not
be prevented or detected on a timely basis by
internal control system
• The assessment can be made at:
• Overall financial statement level
• Account or assertion level
7-26
FACTORS LEADING TO A HIGHER
ASSESSMENT OF CONTROL RISK
7-27
ASSESSING CONTROL RISK
• Interview relevant parties to understand processes
used by the board and management to manage risk
• Review risk-based approach used by internal audit
function with its director and audit committee
• Interviewing management about:
• Risk approach
• Risk preferences
• Risk appetite
• Relationship of risk analysis to strategic planning
7-28
USE PLANNING ANALYTICAL
PROCEDURES TO IDENTIFY
AREAS OF HEIGHTENED RISK
OF MATERIAL MISSTATEMENT
PLANNING ANALYTICAL PROCEDURES
7-30
AN EXAMPLE OF A PLANNING
ANALYTICAL PROCEDURE
• The auditor may develop an expectation of revenue
based on production capacity.
• Recorded revenue in excess of this expectation may
indicate a heightened risk of misstatement in the
revenue account—due to either fraud or error.
• The auditor will then want to plan audit procedures
to obtain sufficient appropriate evidence for the
revenue account
7-31
TYPES OF ANALYTICAL PROCEDURES
• Trend analysis: Based on the history of changes in
the account or ratio
• Ratio analysis: Identifies relevant ratios to determine
whether there are significant differences between
the client results and auditor expectations
See Exhibit 7.3 for Commonly Used Ratios
7-32
DESCRIBE HOW AUDITORS
MAKE DECISIONS ABOUT
DETECTION RISK AND AUDIT
RISK
DETERMINING AUDIT RISK AND
DETECTION RISK
• Detection risk is affected by:
• Effectiveness of substantive auditing procedures
performed
• Extent to which the procedures were performed with
due professional care
• High level of detection risk
• Audit firm is willing to take higher risk of not detecting
a material misstatement
• Audit risk is also high
7-34
QUANTITATIVE EXAMPLE: HIGH RISK
OF MATERIAL MISSTATEMENT
• Assuming an account with many complex
transactions and weak internal controls
• Inherent risk and control risk assessed at their
maximum
• Audit risk set at a low level
• Audit risk model
Audit Risk = Inherent Risk × Control Risk × Detection Risk
0.01 = 1.00 × 1.00 × Detection Risk
Detection Risk = 0.01 / (1.0 × 1.0) = 1%
7-35
QUANTITATIVE EXAMPLE: LOW RISK OF
MATERIAL MISSTATEMENT
• Assuming an account with simple transactions and
well-trained personnel with no incentive to misstate
financial statements
• Inherent risk and control risk assessed at 50% and 20%
respectively
• Audit risk set at 5%
Audit Risk = Inherent Risk × Control Risk × Detection Risk
0.05 = 0.50 × 0.20 × Detection Risk
Detection Risk = 0.05 / (0.50 × 0.20) = 50%
7-36
RESPOND TO THE ASSESSED
RISKS OF MATERIAL
MISSTATEMENT AND PLAN
THE PROCEDURES TO BE
PERFORMED ON AN AUDIT
ENGAGEMENT
PLANNING AUDIT PROCEDURES TO RESPOND TO
THE ASSESSED RISKS OF MATERIAL MISSTATEMENT
• Auditor should determine whether the audit will be:

• Controls reliance audit
• Substantive audit
7-38
PLANNING AUDIT PROCEDURES TO RESPOND TO
THE ASSESSED RISKS OF MATERIAL MISSTATEMENT
7-39
RISK RESPONSES
7-40

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PLANNING THE AUDIT:

IDENTIFYING AND RESPONDING

7. Describe how auditors make decisions about

DESCRIBE THE CONCEPT OF MATERIAL MISSTATEMENT

• (1) are a matter of professional judgment

See Exhibit 7.3 for Commonly Used Ratios

• Auditor should determine whether the audit will be:

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