1. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3-1 Chapter Three Risk Assessment and Materiality Chapter Three Risk Assessment and Materiality

2. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3-2 Audit Risk The risk that an auditor will issue an unmodified opinion on materially misstated financial statements. Financial statement level Individual account balance or class of transactions level

3. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3-3 Auditor’s Business Risk An auditor’s exposure to financial loss and damage to professional reputation. Client and third party lawsuits Negative publicity

4. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3-4 The Audit Risk Model Audit Risk = IR × CR × DR Inherent risk and control risk: Risk that material misstatements exist Non-sampling risk Sampling risk Detection risk: Risk that auditor will not detect misstatements Inappropriate audit procedure Fail to detect when using appropriate audit procedure Misinterpreting audit results

5. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3-5 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:  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.

6. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3-6 Using the Audit Risk Model

7. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3-7 Using the Audit Risk Model Qualitative terms may also be used in the audit risk model.

8. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3-8 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.

9. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3-9 The Auditor’s Risk Assessment Process

10. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3-10 Understanding the Entity and Its Environment Industry Factors Regulatory Environment Nature of the Entity Internal Control Objectives and Strategies Business Risks Financial Performance

11. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3-11 Auditor’s Risk Assessment Procedures Inquiries of Management and Others Analytical Procedures Observation and Inspection

12. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3-12 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. 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.

13. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3-13 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. 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.

14. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3-14 Assessing the Risk of Material Misstatement Due to Error or Fraud Types of misstatements 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 the (applicable) financial reporting framework. The omission of a financial statement element, account, or item. A financial statement disclosure that is not presented in accordance with the financial reporting framework. The omission of information required to be disclosed in accordance with the financial reporting framework. Types of misstatements 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 the (applicable) financial reporting framework. The omission of a financial statement element, account, or item. A financial statement disclosure that is not presented in accordance with the financial reporting framework. The omission of information required to be disclosed in accordance with the financial reporting framework.

15. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3-15 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. 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.

16. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3-16 Assessing the Risk of Material Misstatement Due to Error or Fraud Fraud involves intentional misstatements. Fraudulent financial reporting Misappropriation of assets

17. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3-17 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. 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.

18. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3-18 Misappropriation of assets involves the theft of an entity’s assets to the extent that financial statements are misstated. Examples include: Assessing the Risk of Material Misstatement Due to Error or Fraud Stealing assets Embezzling cash received Paying for goods and services not received

19. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3-19 Risk Factors for Misappropriation of Assets Access to assets Inadequate separation of duties No mandatory vacation policy Personal financial pressures Adverse employee management relationships Small, valuable inventory items Sudden changes in employee behavior Lack of inventory control

20. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3-20 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

21. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3-21 Risk Factors Relating to Incentive/Pressure Financial stability or profitability is threatened Excessive pressure for management to meet third party expectations Management’s personal financial situation is threatened Excessive pressure for management to meet financial targets

22. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3-22 Risk Factors Relating to Opportunities Ineffective monitoring of management Nature of the industry Deficient internal control Complex or unstable organizational structure

23. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3-23 Risk Factors Relating to Attitudes/Rationalizations Poor communication channels for reporting inappropriate behaviour Weak ethical standards for management behaviour Weak ethical standards for management behaviour Failure to correct known reportable conditions Use of inappropriate accounting based on materiality

24. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3-24 The Fraud Risk Identification Process Sources of information Discussion among the audit team Inquiries of management and others Fraud risk factors Analytical procedures Other relevant information

25. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3-25 Auditor’s Response to the Risk Assessment Assess the risk of material misstatement. Determine audit procedures that are necessary based on the risk assessment. High risk Low risk Issue audit report. Design and perform extended procedures. Design and perform normal procedures. Evaluate whether sufficient audit evidence was obtained and if the risk assessments were appropriate.

26. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3-26 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, those charged with governance, and others. 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, those charged with governance, and others.

27. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3-27 Materiality Omissions or misstatements of items are material if they could, individually or collectively, influence the economic decisions of users taken on the basis of the financial statements. Materiality depends on the size and nature of the omission or misstatement judged in the surrounding circumstances. The size or nature of the item, or a combination of both, could be the determining factor. Materiality is a matter of professional judgment.

28. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3-28 Materiality The quantitative base for materiality is a percentage (typically 3 to 5 percent) of: Total assets. Total revenues. Net income before taxes. Net income from continuing operations. Gross profit Three-year average of net income before taxes. The quantitative base for materiality is a percentage (typically 3 to 5 percent) of: Total assets. Total revenues. Net income before taxes. Net income from continuing operations. Gross profit Three-year average of net 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. 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.

29. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3-29 Steps in Applying Materiality on an Audit Establish a preliminary judgment about materiality. Determine tolerable misstatement. Estimate likely misstatements and compare totals to the preliminary judgment about materiality.

30. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 3-30 End of Chapter 3