1. Risk Assessment and Materiality
Chapter 3
Risk Assessment and Materiality
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

2. LO# 1
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

3. LO# 1
Engagement Risk
Client and third party lawsuits
An auditor’s exposure to financial loss and damage to professional reputation.
Negative publicity/reputation
Local audit
failure …

4. Risk Control
Engagement Risk - Cannot be directly controlled, but can have some control via client acceptance/continuance
Audit Risk – Can be directly controlled by scope of the auditor’s work
(scope – nature, timing, extent of audit procedures

5. Terminology
Audit Risk – the risk that the auditor may fail to modify the opinion on materially misstated financial statements
Inherent Risk – susceptibility of an assertion to material misstatements, assuming no related controls
Control Risk – Risk that controls don’t work
Detection Risk – Auditor didn’t catch misst

6. Inherent Risk and Control risk
Functions of the entity
Auditor has little control over these risks
Also called “auditee risk”

7. Detection Risk Can be controlled by the Auditor
Via scope of audit procedures
Inverse relationship to IR and CR

8. The Audit Risk Model Audit Risk = IR × CR × DR
LO# 2
The Audit Risk Model
Inherent risk and control risk: Risk that material misstatements exist
Audit Risk = IR × CR × DR
Detection risk: Risk that auditor will not detect misstatements
Nonsampling risk
Sampling risk
Inappropriate audit procedure
Fail to detect when using appropriate audit procedure
Misinterpreting audit results

9. Using the Audit Risk Model
LO# 3
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.

10. Using the Audit Risk Model
LO# 3
Using the Audit Risk Model
Qualitative terms may also be used in the audit risk model.

11. Limitations of the Audit Risk Model
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.
Preliminary
Assessment Level of Risk
Actual
or Achieved
Level of Risk
+ / –

12. The Auditor’s Risk Assessment Process
LO# 5
The Auditor’s Risk Assessment Process
Auditors need to identify business risks and understand the potential misstatements that may result.
Business risks include any external or internal factors, pressures, and forces that bear on the entity’s ability to survive and be profitable.

13. The Auditor’s Risk Assessment Process
LO# 5
The Auditor’s Risk Assessment Process

14. Understanding the Entity and Its Environment
LO# 5
Understanding the Entity and Its Environment
Financial Performance
Industry Factors
Regulatory Environment
Objectives and Strategies
Internal Control
Business Risks
Nature of the Entity

15. Auditor’s Risk Assessment Procedures
LO# 5
Auditor’s Risk Assessment Procedures
Inquiries of Management and Others
Analytical Procedures
Observation and Inspection

16. Identifying Business Risks
LO# 5
Identifying Business Risks
Examples of conditions or events that indicate the existence of business risks:
Significant changes in the entity (e.g., acquisitions and reorganizations).
Significant changes in the industry.
Significant new products, services, or lines of business.
New locations.
Significant changes in the IT environment.
Operations in areas with unstable economies.
High degree of complex regulation.

17. Assessing the Risk of Material Misstatement Due to Error or Fraud
LO# 6
Assessing the Risk of Material Misstatement Due to Error or Fraud
To assess the risk of material misstatement, the auditor:
Identifies risks by considering the entity and its environment, including controls that relate to the risks,and by relating these risks to the classes of transactions and account balances in the financial statements.
Relates the identified risks to what can go wrong at the assertion level.
Considers whether the risks are of a magnitude that could result in a material misstatement.
Considers the likelihood that the risks will result in a material misstatement.

18. Assessing the Risk of Material Misstatement Due to Error or Fraud
LO# 6
Assessing the Risk of Material Misstatement Due to Error or Fraud
Types of misstatements include:
A difference between the amount, classification, or presentation of a reported financial statement element, account, or item and the amount, classification, or presentation that would have been reported under GAAP.
The omission of a financial statement element, account, or item.
A financial statement disclosure that is not presented in accordance with GAAP.
The omission of information required to be disclosed in accordance with GAAP.

19. Assessing the Risk of Material Misstatement Due to Error or Fraud
LO# 6
Assessing the Risk of Material Misstatement Due to Error or Fraud
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.

20. Assessing the Risk of Material Misstatement Due to Error or Fraud
LO# 6
Assessing the Risk of Material Misstatement Due to Error or Fraud
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
Conditions indicative of fraud
Incentives/pressures
Opportunities
Attitudes/rationalization
Auditor identifies risks of material misstatement due to fraud.

21. Assessing the Risk of Material Misstatement Due to Error or Fraud
LO# 6
Assessing the Risk of Material Misstatement Due to Error or Fraud
Three conditions usually exist when fraud occurs.
Incentive or pressure to commit fraud
Opportunity to commit fraud
Attitude or rationalization to justify fraud

22. Assessing the Risk of Material Misstatement Due to Error or Fraud
LO# 6
Assessing the Risk of Material Misstatement Due to Error or Fraud
Fraud involves intentional misstatements.
Fraudulent financial reporting
Misappropriation of assets

23. Assessing the Risk of Material Misstatement Due to Error or Fraud
LO# 6
Assessing the Risk of Material Misstatement Due to Error or Fraud
Fraudulent financial reporting includes acts such as the following:
Manipulation, falsification, or alteration of accounting records or supporting documents used to prepare financial statements.
Misrepresentation in, or intentional omission from, the financial statements of events, transactions, or significant information.
Intentional misapplication of accounting principles relating to amount, classification, manner of presentation, or disclosure.

24. Assessing the Risk of Material Misstatement Due to Error or Fraud
LO# 6
Assessing the Risk of Material Misstatement Due to Error or Fraud
Fraudulent Financial Reporting
Risk Factors Relating to Incentive/Pressure include:
Excessive pressure for management to meet financial targets
Excessive pressure for management to meet third party expectations
Management’s personal financial situation is threatened
Financial stability or profitability is threatened

25. Assessing the Risk of Material Misstatement Due to Error or Fraud
LO# 6
Assessing the Risk of Material Misstatement Due to Error or Fraud
Fraudulent Financial Reporting
Risk Factors Relating to Opportunities include:
Nature of the industry
Complex or unstable organizational structure
Ineffective monitoring of management
Deficient internal control

26. Risk Factors Relating to Attitudes/Rationalizations
LO# 6
Risk Factors Relating to Attitudes/Rationalizations
Fraudulent Financial Reporting
Risk Factors Relating to Attitudes/Rationalizations include:
Use of inappropriate accounting based on materiality
Poor communication channels for reporting inappropriate behavior
Failure to correct known reportable conditions
Weak ethical standards for
Management behavior

27. Assessing the Risk of Material Misstatement Due to Error or Fraud
LO# 6
Assessing the Risk of Material Misstatement Due to Error or Fraud
Misappropriation of assets involves the theft of an entity’s assets to the extent that financial statements are misstated. Examples include:
Stealing assets
Paying for goods and services not received
Embezzling cash received

28. Assessing the Risk of Material Misstatement Due to Error or Fraud
LO# 6
Assessing the Risk of Material Misstatement Due to Error or Fraud
Misappropriation of Assets
Risk Factors for Misappropriation of Assets include:
Personal financial pressures
Access to assets
Adverse employee management relationships
Lack of inventory control
Inadequate separation of duties
No mandatory vacation policy
Small, valuable inventory items
Employee
disregard
of internal
control
Sudden changes in employee behavior

29. Types of items Requiring Specific Audit Procedures
Assertions identified with Fraud risk
Nonroutine/unsystematically processed transactions
Significant accounting estimates and judgements
Highly complex transactions
Application of new accounting standards
Revenue recognition issues

30. Evaluation of Audit Test Results
LO# 8
Evaluation of Audit Test Results
At the completion of the audit, the auditor should consider whether the accumulated results of audit procedures affect the assessments of the entity’s business risk and the risk of material misstatement. The total uncorrected misstatements that were detected should be aggregated to determine if they cause the financial statements to be materially misstated. If the auditor concludes that the total misstatements cause the financial statements to be materially misstated, the auditor should request management to eliminate the material misstatement. If the management does not do so, the auditor should issue a qualified or adverse opinion.
If the auditor determines that the misstatement is or may be the result of fraud, and either has determined that the effect could be material or has been unable to evaluate whether the effect is material, the auditor should:

31. Evaluation of Audit Test Results
LO# 8
Attempt to obtain audit evidence to determine whether, in fact, material fraud has occurred and, if so, its effect.
Consider the implications for other aspects of the audit.
Discuss the matter and the approach to further investigation with an appropriate level of management that is at least one level above those involved in committing the fraud and with senior management.
If appropriate, suggest that the client consult with legal counsel.
If the results of the audit tests indicate a significant risk of fraud, the auditor should consider withdrawing from the engagement and communicating the reasons for withdrawal to the audit committee or others with equivalent authority and responsibility.

32. Documentation of the Auditor’s Risk Assessment
LO# 9
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.

33. Communications about Fraud
LO# 10
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.

34. Communications about Fraud
LO# 10
The disclosure of fraud to parties other than the client’s senior management and its audit committee ordinarily is not part of the auditor’s responsibility and ordinarily would be precluded by the auditor’s ethical and legal obligations of confidentiality. However, the auditor may have a duty to make disclosure to others outside the entity when the following conditions exist:
To comply with certain legal and regulatory requirements.
To a successor auditor when the successor makes inquiries in accordance with AU 315, Communications between Predecessor and Successor Auditors.
In response to a subpoena.
To a funding agency or other specified agency in accordance with requirements for the audits of entities that receive governmental financial assistance.

35. LO# 11
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.

36. LO# 11
Materiality
The quantitative base for materiality is a percentage (typically 3 to 5 percent) of:
Total assets.
Total revenues.
Income before taxes.
Income from continuing operations.
Gross profit
Three-year average of income before taxes.
The quantitative amounts may be adjusted lower for qualitative factors such as:
First-year engagement.
Control weaknesses.
Management turnover.
High market pressures.
High fraud risk.
Higher than normal risk of bankruptcy.

37. Steps in Applying Materiality on an Audit
LO# 12
Steps in Applying Materiality on an Audit
Step 1:
Determine a material 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)

38. End of Chapter 3