Define risk in AUDITING Auditors accept some level of risk or uncertainty in performing audits. Risk of Material Misstatement at the Overall Financial Statement Level: Refers to the risks that relate pervasively to the financial statements as a whole and potentially affect a number of different transactions and accounts. Risk of Material Misstatement at the Assertion Level: There are two components to risk at the assertion level: Inherent risk—Susceptibility of an assertion to material misstatement. Control risk—Risk that internal controls will not prevent or detect material misstatement. There are several types of risk in auditing. This chapter defines and discusses the types of risks, their relationships, and how they affect what the auditor does. Copyright © 2017 Pearson Education, Inc.

risk assessment procedures Risk assessment procedures include the following: Inquiries of management and others within the entity Analytical procedures Observation and inspection Discussion among engagement team members Other risk assessment procedures The role of risk assessment procedures is detailed in Figure 9-1. Because there are risks with any audit, risk assessment procedures are part of the audit planning process. Copyright © 2017 Pearson Education, Inc.

considering fraud risk Risk assessment procedures include assessing the risk of material misstatement due to fraud or error. The auditor’s consideration of fraud risk is made at both the Financial statement level and Assertion level for classes of transactions, account balances, and presentation and disclosures. Because several high-profile cases of financial statement fraud involve misstatements in revenue recognition, auditing standards require the auditor to presume that risks of fraud exist in revenue recognition. Part of risk assessment is assessing the risk of fraud at both the financial statement level and at the assertion level for classes of transactions. Copyright © 2017 Pearson Education, Inc.

Identification of significant risks Auditor must determine whether any of the risks identified are a significant risk. A significant risk is any risk that the auditor deems to require special attention. Nonroutine transactions, including related-party transactions, often represent significant risk. Account balances or transactions that require estimates for which significant measurement uncertainty exists also may require more attention. All fraud risks are normally considered to be significant risks. Copyright © 2017 Pearson Education, Inc.

Audit risk model The risk of material misstatement at the assertion level consists of two components: inherent risk and control risk. Auditors consider these risks by applying the audit risk model: The relationship between the audit risk model and the understanding of the client’s business and industry is shown in Figure 9-2. An illustration of risks and evidence is shown in Table 9-1. Copyright © 2017 Pearson Education, Inc.

Audit risk model (cont.) Planned Detection Risk: The risk that the audit evidence for an audit objective will fail to detect misstatements exceeding performance materiality. Planned detection risk is dependent on the other three factors in the model and will change only if the auditor changes one of the other factors. Inherent Risk: The auditor’s assessment of the susceptibility of an assertion to material misstatement. Control Risk: The auditor’s assessment of the risk that a material misstatement could occur in an assertion and not be prevented or detected by the client’s internal controls. Acceptable Audit Risk: How willing the auditor is to accept that the financial statements may be materially misstated after the audit is complete and an unmodified opinion has been issued. The audit risk model uses all four types of risk to determine the risk involved in an audit. Copyright ©2017 Pearson Education, Inc.

Assessing acceptable Audit risk Auditors must decide appropriate acceptable audit risk. Auditors must first decide engagement risk and use it to modify acceptable audit risk. Engagement risk is the risk that the auditor (or firm) will suffer harm after the audit is finished, even though the report was correct. Engagement risk is closely related to client business risk because the risk that the auditor will be sued is often related to business failure after the audit is finished. Acceptable audit risk must be determined in order for the auditor to properly plan the audit. Copyright © 2017 Pearson Education, Inc.

Assessing acceptable Audit risk (cont.) Factors Affecting Acceptable Audit Risk: The degree to which external users rely on the statements based on these factors: Client size Distribution of ownership Nature and amount of liabilities The likelihood that a client will have financial difficulties after the audit based on these factors: Liquidity position Profits (losses) in previous years Method of financing growth Nature of the client’s operations Competence of management The auditor’s evaluation of management’s integrity Assessing acceptable risk depends on the factors listed on this slide—many of these items are also used in gaining an understanding of the client, its business, and the industry in which it operates. Copyright ©2017 Pearson Education, Inc.

Assessing acceptable Audit risk (cont.) Making the Acceptable Audit Risk Decision Copyright ©2017 Pearson Education, Inc.

Assessing inherent risk Assessing inherent risk is an attempt by the auditor to predict where misstatements are most and least likely in the financial statement segments. This affects the amount of audit evidence that the auditor needs to accumulate. The auditor must assess the factors that make up the risk and modify procedures for audit evidence to take them into consideration. This consideration takes place during the planning phase and is updated throughout the audit process. Inherent risk is the amount of risk involved with an account balance or class of transactions that comes from the type of account or transaction that it is. Copyright © 2017 Pearson Education, Inc.

Assessing inherent risk (cont.) Factors to Consider when Assessing Inherent Risk: Nature of the client’s business Results of previous audits Initial versus repeat engagement Related parties Complex or nonroutine transactions Judgment required to correctly record account balances and transactions Makeup of the population Factors related to fraudulent financial reporting Factors related to misappropriation of assets Copyright ©2017 Pearson Education, Inc.

Relationship of risks to evidence and factors influencing risks Figure 9-3 summarizes the relationship of risk factors and audit evidence. In addition to modifying audit evidence, the auditor can also make the following changes to respond to risks: The engagement may require more experienced staff. The engagement will be reviewed more carefully than usual. Copyright © 2017 Pearson Education, Inc.

Relationship of risks to evidence and factors influencing risks (cont Audit Risk for Segments—The risk of material misstatement, control risk, and inherent risk are assessed for each audit objective in each segment of the audit. Relating Performance Materiality and Risks to Balance-Related Audit Objectives—Although it is common to assess inherent and control risks for each balance-related audit objective, it is not common to allocate materiality to those objectives. Measurement Limitations—One major limitation in the application of the audit risk model is the difficulty of measuring the components of the model. It is a highly subjective process, so most auditors use broad categories such as low, medium, and high. This is illustrated in Table 9-3. Copyright ©2017 Pearson Education, Inc.

Relationship of risks to evidence and factors influencing risks (cont Tests of Details of Balances Evidence-Planning Worksheet—Auditors develop various types of decision aids to help link judgments affecting audit evidence with appropriate evidence to accumulate. One such worksheet is illustrated in Figure 9-4. Revising Risks and Evidence—The audit risk model is primarily a planning model and is of limited use in evaluating results. If audit evidence suggests that the risk is higher than originally thought, the auditor must revise the original assessment and consider the effect of the revision on evidence requirements. Copyright ©2017 Pearson Education, Inc.

Copyright ©2017 Pearson Education, Inc.

Relationship of risk and materiality to audit evidence The concepts of materiality and risk in auditing are closely related and inseparable. Risk is a measure of uncertainty. Materiality is a measure of magnitude. The relationships among performance materiality and the four risks to planned audit evidence are shown in Figure 9-5. Copyright © 2017 Pearson Education, Inc.