Introduction to Risk Assessment and Materiality
- 1. 3-1 Chapter 3 Risk Assessment and Materiality Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin
- 2. 3-2 Audit Risk The risk that an auditor will issue an unqualified opinion on materially misstated financial statements. Financial statement level Individual account balance or class of transactions level LO# 1
- 3. 3-3 Engagement Risk An auditor’s exposure to financial loss and damage to professional reputation. Client and third party lawsuits Negative publicity LO# 1 Local audit failure …
- 4. 3-4 The Audit Risk Model Audit Risk = IR × CR × DR Inherent risk and control risk: Risk that material misstatements exist Nonsampling risk Sampling risk Detection risk: Risk that auditor will not detect misstatements • Inappropriate audit procedure • Fail to detect when using appropriate audit procedure • Misinterpreting audit results LO# 2
- 5. 3-5 Using the Audit Risk Model Set a planned level of audit risk such that an opinion can be issued on the financial statements. Assess inherent risk and control risk. Use the audit risk equation to solve for the appropriate level of detection risk: AR = IR × CR × DR DR = AR IR × CR Auditors use this level of detection risk to design audit procedures that will reduce audit risk to an acceptable level. LO# 3
- 6. 3-6 Limitations of the Audit Risk Model Preliminary Assessment Level of Risk Actual or Achieved Level of Risk LO# 4 + / – The audit risk model is a planning tool, but it has some limitations that must be considered when the model is used to revise an audit plan or to evaluate audit results. • The desired level of audit risk may not actually be achieved. • It does not consider potential auditor error. • There is not way of knowing what the preliminary level of risk actually was.
- 7. 3-7 The Auditor’s Risk Assessment Process Figure 3-2 An Overview of the Auditor’s Assessment of Business Risks and Risk of Material Misstatements LO# 5
- 8. 3-8 Errors are unintentional misstatements: Mistakes in gathering or processing financial data used to prepare financial statements. Unreasonable accounting estimates arising from oversight or misinterpretation of facts. Mistakes in the application of accounting principles relating to amount, classification, manner of presentation, or disclosure. LO# 6 Assessing the Risk of Material Misstatement Due to Error or Fraud
- 9. 3-9 Fraud involves intentional misstatements. The fraud risk identification process includes: Sources of information about possible fraud Communications among the audit team Inquires of management and others Fraud risk factors Analytical procedures Other information LO# 6 Assessing the Risk of Material Misstatement Due to Error or Fraud
- 10. 3-10 Three conditions usually exist when fraud occurs. Incentive or pressure to perpetrate fraud Opportunity to carry out the fraud Attitude or rationalization to justify fraud LO# 6 Assessing the Risk of Material Misstatement Due to Error or Fraud (Fraud Triangle)
- 11. 3-11 Auditor’s Response to the Risk Assessment (See Figure 3-3) Financial statement level risks Develop an overall response. Determine what can go wrong at the account or assertion level. LO# 7 Assess the risk of material misstatement at the financial statement and assertion levels. Do these risks relate pervasively to the financial statements? Design audit procedures for assertion level risks. Assertion level risks Yes No
- 12. 3-12 Evaluation of Audit Test Results At the completion of the audit, the auditor should consider: 1. whether the accumulated results of audit procedures affect the assessments of the entity’s business risk and the risk of material misstatement, and 2. whether the total misstatements cause the financial statements to be materially misstated. THEN… If the financial statements are materially misstated, the auditor should 1. request management to eliminate the material misstatement, or 2. if management does not make needed adjustments, the auditor should issue a qualified or adverse opinion. LO# 8
- 13. 3-13 Documentation of the Auditor’s Risk Assessment The auditor should document: Discussions among engagement personnel. Procedures performed to identify and assess the risks of material misstatement due to fraud. Risks of identified material misstatement due to fraud and a description of the auditor’s response to the risks. Fraud risks or other conditions that result in additional audit procedures. The nature of the communications about fraud made to management, the audit committee, and others. LO# 9
- 14. 3-14 Communications about Fraud Whenever the auditor has found evidence that a fraud may exist, that matter should be brought to the attention of an appropriate level of management. Fraud involving senior management and fraud that causes a material misstatement of the financial statement should be reported directly to the audit committee of the board of directors. The auditor should reach an understanding with the audit committee regarding the expected nature and extent of communications about misappropriations perpetrated by lower- level employees. LO# 10
- 15. 3-15 Materiality The magnitude of an omission or misstatement of accounting information that makes it probable that the judgment of a reasonable person relying on the information would be changed or influenced by the omission or misstatement. Materiality is not an absolute and it is not a black or white issue! The determination of materiality requires professional judgment. LO# 11
- 16. 3-16 Steps in Applying Materiality on an Audit Step 1: Determine a materiality level for the overall financial statements (planning materiality) Step 2: Determine tolerable misstatement (allocation of materiality at individual account/class of transactions level) Step 3: Evaluate auditing findings (near the end of the audit) LO# 12
- 17. 3-17 End of Chapter 3 Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin