Presentation on theme: "Audit Risk The possibility that the auditors may unknowingly fail to appropriately modify their opinion on financial statements that are materially misstated."— Presentation transcript:
2 Audit RiskThe possibility that the auditors may unknowingly fail to appropriately modify their opinion on financial statements that are materially misstatedThis is the risk that the auditors will issue an unqualified opinion on financial statements that contain a material departure from GAAP.Auditors must obtain sufficient appropriate audit evidence to reduce audit risk to a low level in every audit.
3 Financial Statement Assertions Relevant assertions are those that, without regard for controls, have a reasonable possibility of containing a material misstatement; typesAssertions about account balances (Accounts)Assertions about classes of transactions and events (Transactions)Assertions about presentation and disclosure (Disclosures)
4 Financial Statement Assertions: Auditing Standards Board and International Standards AccountsTransactionsDisclosuresExistenceOccurrenceRights and obligationsCompletenessValuation and allocationAccuracyAccuracy and valuationCutoffClassificationClassification and understandability
5 Combined Assertions Used in this Text Existence or Occurrence--Assets, liabilities, and equity interests exist and recorded transactions have occurredRights and Obligations--The company holds rights to the assets, and liability are the obligations of the companyCompleteness--All assets, liabilities, equity interests, and transactions that should have been recorded have been recordedCutoff—Transactions and events have been recorded in the correct accounting periodValuation, Allocation and Accuracy—All transactions, assets, liabilities and equity interests are included in the financial statements at proper amountsPresentation and Disclosure--Accounts are described and classified in accordance with generally accepted accounting principles, and financial statement disclosures are complete, appropriate, and clearly expressed22
6 Audit Risk Risk of Material Risk That the Audit Risk = Misstatement * Auditors Fail tothe Misstatement= Inherent Control DetectionRisk * Risk * RiskInherent Risk--Risk of a material misstatement occurring in an assertion assuming no related internal controls.Control Risk--Risk that a material misstatement in an assertion will not be prevented or detected on a timely basis by the company’s internal control.Detection Risk--Risk that the auditors’ procedures will lead them to conclude that a material misstatement does not exist in an assertion when in fact such misstatement does exist.33
7 Audit Risk Formula AR = IR * CR * DR AR = Audit risk IR = Inherent riskCR = Control riskDR = Detection risk44
9 Inherent Risk Factors that affect inherent risk: Nature of the client and its environmentNature of the particular financial statement elementBusiness characteristics indicative of high inherent risk:Inconsistent profitability of clientOperating results highly sensitive to economic factorsGoing concern problemsLarge known and likely misstatements detected in prior auditsSubstantial turnover, questionable reputation, or inadequate accounting skills of management
10 Assertions with high inherent risk Involve:Difficult to audit transactions or balancesComplex calculationsDifficult accounting issuesSignificant judgment by managementValuations that vary significantly based on economic factors
11 Types of Transactions Routine Nonroutine Estimation transactions Recurring financial statement activities recorded in the accounting records in the normal course of businessLower inherent riskNonroutineInvolve activities that occur only periodically such as the taking of physical inventoriesHigh inherent riskEstimation transactionsActivities that create accounting estimatesHigher inherent risk
12 Appropriateness of Audit Evidence0 Auditor must obtain sufficient appropriate audit evidence.To be appropriate audit evidence must be:RelevantReliablePrinciples—Audit evidence is ordinarily more reliable when it isObtained from knowledgeable independent sources outside the company rather than nonindependent sourcesGenerated internally through a system of effective controls rather than ineffective controls.Obtained directly by the auditor rather than indirectly or by inferenceDocumentary in form rather than oralProvided by original documents rather than copies77
13 Reliability of Certain Types of Audit Evidence RELIABILITY TYPE EXAMPLEHigh Physical Inventory ObservationDocumentaryExternal Cutoff Bank StatementExternal/Internal Purchase InvoiceInternal Sales InvoiceLow Client Representations Management RepresentationLetter88
14 Types of Audit Evidence Accounting information systemDocumentary evidenceThird-party representationsPhysical evidenceComputationsData interrelationshipsClient representations
16 Overall Types of Audit Procedures Risk assessment proceduresTo obtain an understanding of the client and its environment, including its internal control, to assess the risks of material misstatementFurther Audit ProceduresTests of controlsWhen appropriate, to test the operating effectiveness of controls in preventing material misstatementsSubstantive proceduresTo detect material misstatements at relevant assertion level. Substantive procedures include (a) analytical procedures, (b) tests of details of account balances, transactions and disclosures
17 Substantive Procedures Analytical proceduresTests of detailsTests of account balancesTests of classes of transactionsTests of disclosuresOne may change the scope of audit procedures by changing the (NTE, or re-ordered as NET):Nature (type and form)Timing (when performed)Extent (quantity of evidence obtained)
18 Nature and Timing of Procedures Holding the extent of procedures constant, one may increase the scope of procedures (make them more effective) by either changing theNature-- obtain more reliable evidenceoften externally generated evidence.Timing--wait until year-end to obtain evidence from entire set of transactions as contrasted to performing interim testing, say two months prior to year-end and simply updating those procedures.
19 Extent of ProceduresHolding other factors such as the nature and timing of procedures constant:The greater the risk of material misstatement, the greater the needed extent of substantive proceduresThe main way to increase the extent of audit procedures is to examine more itemsSample sizes should reduce detection risk so as to restrict audit risk to a low level
20 General on Analytical Procedures (1 of 3) Timing of analytical proceduresRisk assessment (sometimes referred to as planning analytical procedures)Substantive proceduresFinal reviewSteps involvedDevelop expectation of account (or ratio) balanceDetermine amount of difference that can be accepted without investigationCompare the company’s account (ratio) with the expectationInvestigate and evaluate significant differences
21 General on Analytical Procedures (2 of 3) Developing an expectationPrior period informationAnticipated resultsRelationships among elements of financial information within a periodIndustry informationRelationships between financial information and relevant nonfinancial data.
22 General on Analytical Procedures (3 of 3) Types of ExpectationsTrend analysis—analyze changes in accounts of a company over timeRatio analysis – compare relationships between two or more financial statement accounts or comparisons of account balances to nonfinancial dataLiquidity (e.g., current ratio)Leverage (e.g., debt to equity)Profitability (e.g., gross profit percentage)Activity (e.g., inventory turnover)
23 Ratio Analysis Approaches to ratio analysis Horizontal analysis Review ratios over timeCross sectional analysisAnalyze ratios of similar firms at a point in timeVertical analysisAnalyze relationships within a period“Common size” statements preparedOther methodsRegression analysis, reasonableness test
25 Basic Approaches to Auditing Accounting Estimates Review and test management’s process for developing the estimate.Independently develop an estimate to compare to management’s estimate.Review subsequent events or transactions bearing on the estimate.1010
26 Auditing Fair ValuesInputs to use in applying valuation techniques (FAS 157)Level 1 – inputs of observable quoted prices in active markets for identical assets or liabilitiesEx. A closing stock price in WSJLevel 2 – inputs of observable quoted prices, generally for similar assets or liabilities in active marketsEx. Company discounts future cash flows on its not publicly traded debt securities at rate used by market for publicly traded debt securitiesLevel 3 – inputs that are unobservable for the assets or liabilityEx. A private company uses judgment to determine a proper rate to discount the future cash flows of its not publicly traded securities
27 Related Party Transactions Disclosure requirements must be metPrimary challenge is identifying undisclosed related party transactionsDetermine related partiesInquiries of managementReview SEC filings, stockholder’s listings and conflict-of-interest statementsBe alert for transactions with related parties and any transactions with unusual terms
28 Functions of Audit Documentation Primary functions:Support the auditors’ compliance with auditing standardsSupport the auditors’ opinionSecondary functions:Assist continuing and new audit team members in planning and performing the auditServes as a record of matters of continuing audit interestAssists in supervision and review of the auditDemonstrates the accountability of team membersAssists internal reviewers, external peer reviewers, PCAOB inspectors, and successor auditors in performing their roles1122
29 Sufficiency of Audit Documentation Audit documentation should be sufficient to:Enable an experienced auditor to understand the work performed and the significant conclusions reachedIdentify who performed and reviewed the workShow that the accounting agree or reconcile to the financial statementsAudit documentation should include all significant audit findings and the actions taken to address them
30 Types of Working Papers Audit administrative working papersWorking trial balanceLead schedulesAdjusting journal entries and reclassification entriesSupporting schedulesAnalysis of a ledger accountReconciliationsComputational working papersCorroborating documents
31 Types of Working Files Current files Permanent files Current year working papersIndex and cross-referencingPermanent filesItems of continuing audit interest44
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