1. Audit Risk and Business Risk
Chapter 4
Audit Risk and Business Risk

2. LO1 - Define the Nature of Risk
In this chapter, we will look at three critical components of risk that affect the audit approach and audit outcome
Engagement risk - comes with association with a specific client
Financial reporting risk - those that relate directly to the recording transactions and the presentation of the financial statements
Audit risk - risk an auditor may provide an unqualified opinion on financial statements that are materially misstated
Each of these components can be managed. The effectiveness of risk management processes will determine whether the company continues to exist

3. LO3 - The link between Risk & Control
Controls are implemented to mitigate against risks.
Controls vary and not only include financial controls e.g. bank reconciliation but also includes policy controls which ensue that certain operational procedures and standards are maintained/

4. LO4 - Review Risk Factors Affecting the Audit
1. Engagement Risk
Risk auditors incur by being associated with a particular client
Risk is high whenever there is increased likelihood that
Auditor is associated with a failed client
Financial statements contain material misstatement that the auditor fails to find
These conditions increase the likelihood that the auditor will be sued
Client Acceptance or Retention Decision
Perhaps the most important audit decision
A number of factors affect this decision, but most important involve
Quality of the client's corporate governance
Client's financial health

5. Risk Factors Affecting the Audit - Corporate Governance
The key factors an auditor will analyze include
Management integrity
Independence and competence of the audit committee and board
Quality of ERM and controls
Regulatory and reporting requirements
Participation of key stakeholders
Existence of related party transactions

6. Management integrity - information sources
Predecessor auditor
Other professionals
Other auditors within the audit firm
News media and web searches
Public databases
Preliminary interviews with management
Audit committee members
Inquiries of federal regulatory agencies
Private investigation firms

7. Risk Factors Affecting the Audit - Financial Health of the Organization
There are a number of reasons why the auditor needs to evaluate a potential client's financial health:
The auditor will most likely be sued if a client declares bankruptcy
Investors and creditors who have lost money will look for recovery
Attorneys will claim the financial statements were misstated and the auditors should have known they were misstated
The auditor also needs to understand the financial health in order to:
Assess management's motivation to misstate the financial statements
Identify areas that are likely to be misstated
Identify account balances that appear unusual

8. Risk Factors Affecting the Audit - Other Factors Affecting Engagement Risk
The auditor should evaluate the company's economic prospects to help ensure that
Important areas will be investigated
The company will likely stay in business
High-risk companies are generally characterized by
Inadequate capital
Lack of long-run strategic and operational plans
Low cost entry into the market
Dependence on limited product offerings
Dependence on technology subject to obsolescence
Instability of future cash flows
History of questionable accounting practices
Previous inquiries by the SEC or other regulatory agencies

9. Review Risk Factors Affecting the Audit 2. Financial Reporting Risk
Financial reporting risk is influenced by
The company's financial health
The quality of the company's internal controls
The complexity of the company's transactions and financial reporting
Management's motivation to misstate the financial statements
These factors are interrelated
The auditor will gather information on these issues through reviews of previous audits, or by talking with the predecessor auditor

10. LO5 - Accepting New Clients: Auditing Standards on Auditor Changes
SAS 84 requires a successor auditor to initiate discussions with the predecessor to discuss the reasons for the change in auditors
Because of the confidentiality rule, the successor must first obtain client permission to talk with predecessor
The successor is particularly interested in factors that bear on
Management integrity
Disagreements with management on any substantive auditing or accounting issues
The predecessor's understanding of the reasons for the change
Any communications between the predecessor and management or audit committee regarding fraud, illegal acts or internal control matter

11. Accepting New Clients: Engagement Letter – see page 108-109
The auditor and client should have a mutual understanding of the audit process
The auditor should prepare an engagement letter to clarify the responsibilities and expectations of each party, and to summarize and document this understanding including the
Nature of the services to be provided
Timing of those services
Expected fees and basis on which they will be billed (fixed fee, hourly rates)
Auditor responsibilities including the search for fraud
Client responsibilities including preparing information for the audit
Need for any other services to be performed by the firm

12. Define Materiality
The auditor is expected to plan and perform an audit that provides reasonable assurance that material misstatements will be detected
The FASB defines materiality as the
"magnitude of an omission or misstatement of accounting information that, in light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement"
Materiality has three significant dimensions:
Size of the misstatement (dollar amount)
Circumstances - some things are viewed more critically than others
User impact - impact on potential users and the type of judgments made

13. Comment on Materiality
Determination of materiality is situation specific
Although this makes determination more difficult, it allows the auditor to adjust the rigor of the audit to reflect the risk of the engagement
The lower the dollar amount of set materiality, the more rigorous the examination
Most firms have guidelines for setting materiality
Guidelines usually involve applying percentages to some base e.g. Revenue, Assets, Pre-Tax income
Guidelines may also be based on nature of the industry or other factors
Auditors initially set planning materiality for the statements as a whole, and then allocate this to individual accounts based on their susceptibility to misstatement

14. LO6 – 3. Audit Risk
Audit risk is the risk than an auditor may issue an unqualified opinion on materially misstated financial statements
The auditor assesses engagement risk first, then sets audit risk
Audit risk is inversely related to engagement risk
If the auditor accepts a client with high engagement risk
The auditor must conduct a more rigorous audit. The auditor does this is by setting audit risk at a low level
If the auditor accepts a client with low engagement risk
The auditor can afford to set audit risk at a higher level

15. Review the Audit Risk Model
The auditor sets desired audit risk based on assessed engagement risk
AR = IR x CR x DR
AR = Audit Risk, IR = Inherent Risk, CR = Control Risk
DR = Detection Risk
The audit risk model allows the auditor to consider the following:
Complex or unusual transactions are more likely to recorded in error than are simple or recurring transactions
Management may be motivated to misstate earnings or assets
Better internal controls mean a lesser likelihood of misstatement
The amount and persuasiveness of audit evidence gathered should vary directly with the likelihood of material misstatements

16. Explain the Audit Risk Model
Inherent Risk - Susceptibility of transactions to be recorded in error
Inherent risk is higher for some items:
Complex transactions are more likely to be misstated than simple transactions
Estimated balances more likely to be misstated than fact based balances
The auditor assesses inherent risk
Control Risk - Risk client controls will fail to prevent or detect a misstatement
The quality of controls often varies between classes of transactions
The auditor assesses control risk

17. Explain the Audit Risk Model - 2
Environment Risk - inherent and control risks combined
Detection risk - risk audit procedures will fail to detect material misstatements. It reflects the likelihood of material misstatements occurring
Relates to the effectiveness of audit procedures and their application
Detection risk is controlled by the auditor and is an integral part of audit planning
The level of detection risk set directly determines the rigor of the substantive audit work performed

18. LO7 - Audit Risk Model AR = IR x CR x DR
Audit risk is set inversely to the assessed level of engagement risk
After audit risk is set, the auditor assesses inherent and control (environment) risks
The auditor sets detection risk INVERSELY to environment risk
Example, if the auditor is examining transactions with high inherent risk, or weak controls, the auditor will set a low detection risk

19. Audit Risk Model (cont’d)
Low detection risk means a low probability of NOT detecting material misstatements
To achieve low detection risk, the auditor will have to perform more rigorous substantive testing
For example, larger sample sizes, more reliable forms of evidence, assign more experienced auditors, closer supervision, greater year-end (rather than interim) testing
The audit risk model shows that the amount, nature, and timing of audit procedures depends on the level of audit risk an auditor assumes, and the level of client-related risks

20. Audit Risk Model: Limitations
Inherent risk is difficult to formally assess
Audit risk is subjectively determined
The model treats each risk component as separate and independent when clearly, this is not the case
Audit technology is not so precise that each component can be accurately assessed
Because of these limitations, many auditors use the audit risk model as a functional, rather than mathematical, model

21. Preliminary Financial Statement Review: Techniques & Expectations
Auditors use analytical procedures to develop expectations of account balances
These expectations are compared to recorded book values to identify misstatements
Sources of data commonly used:
Financial information for prior periods
Expected or planned results from budgets and forecasts
Comparison of linked accounts (such as interest expense and debt)
Ratios of financial information (such as common-size financial statements)
Company and industry trends
Relevant non-financial information

22. Preliminary Financial Statement Review: Techniques & Expectations
Techniques commonly used
Trend analysis
Comparative financial statements (horizontal analysis)
Common-sized financial statements (vertical analysis)
Ratio analysis
The results of analytical procedures are placed in context when auditors compare client results to the client's prior performance, industry data, or client expectations (budgets and forecasts)

24. LO9 - Comment on Risk Analysis & Conduct of the Audit
The risk approach means auditors must understand the company and its risks as a basis for determining which account balances should be directly tested and which can be corroborated by analytical procedures
Linkage to direct tests of account balances
If the auditor concludes there is a high risk of material misstatement
s/he must
Set materiality at an appropriate level
Use procedures appropriate for the level risk to examine the account balance

25. Comment on Risk Analysis & Conduct of the Audit
Quality of accounting principles used
The auditor is required to assess the appropriateness of the accounting methods used by management
Guidelines to evaluate "appropriateness" include:
Representational faithfulness - does the accounting reflect the economic substance of the transactions
Consistency of application of GAAP
Accounting estimates - based on proven models, reconciled to actual results, based on valid economic reasons?