1. Chapter 4 Risk Assessment McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

2. LO# 1
Audit Risk
The risk that an auditor expresses an unqualified opinion on materially misstated financial statements.
Financial statement level
Individual account balance or class of transactions level
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3. The Audit Risk Model Audit Risk = IR × CR × DR
LO# 2
The Audit Risk Model
Inherent risk and control risk: Risk of material misstatement
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
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4. Client and third party lawsuits
LO# 2
Engagement Risk
Client and third party lawsuits
An auditor’s exposure to financial loss and damage to professional reputation.
Negative publicity
Local audit
failure …
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5. 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 the risk of material misstatement (IR x CR).
 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.
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6. Limitations of the Audit Risk Model
LO# 3
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 no way of knowing what the preliminary level of risk actually was.
Preliminary
Assessment Level of Risk
Actual
or Achieved
Level of Risk
+ / –
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7. LO# 4
The Auditor’s Risk Assessment Process Figure 4-2 An Overview of the Auditor’s Assessment of Business Risks and the Risk of Material Misstatements
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8. Assessing the Risk of Material Misstatement Due to Error or Fraud
LO# 5
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.
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9. 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
Analytical procedures
Unexpected period-end adjustments
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10. LO# 6
Assessing the Risk of Material Misstatement Due to Error or Fraud (Fraud Triangle)
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
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11. Auditor’s Response to the Risk Assessment (See Figure 4-3)
LO# 7
Assess the risk of material misstatement at the financial statement and assertion levels.
Financial statement level risks
Assertion level risks
Do these
risks relate
pervasively to
the financial
statements? No
Determine what can go wrong
at the account or assertion level.
Design audit
procedures for
assertion level risks.
Yes
Develop an overall
response.
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12. Evaluation of Audit Test Results
LO# 8
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.
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13. 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.
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14. 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.
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15. End of Chapter 4
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