Modern Auditing: Assurance Services and the Integrity of Financial Reporting, 8 th Edition Modern Auditing: Assurance Services and the Integrity of Financial Reporting, 8 th Edition William C. Boynton California Polytechnic State University at San Luis Obispo Raymond N. Johnson Portland State University Chapter 9 – Audit Risk, Including the Risk of Fraud

Chapter 9 Overview

Audit Risk – An Overview Concept of Audit Risk – Inverse of reasonable assurance – If 99% certainty is desired, the audit risk is 1% Professional Judgment and Audit Risk – Usually audit firm policy – Comparable from one audit to another

Fraud Defined Acts Resulting in Material Misstatements – Fraud or Error – Intentional or Unintentional 2 Types of Misstatements Relevant to Fraud – Fraudulent Financial Reporting – Misappropriation of Assets

The Fraud Triangle

Fraudulent Financial Reporting Incentives and Pressures Opportunity Attitudes and Rationalization

Misappropriation of Assets Incentives and Pressures Opportunity Rationalization

Auditing for Fraud Risk Assessment Procedures Brainstorming Session Specific Risks

Risk Assessment Procedures Inquiries of Management Consider Unusual or Unexpected Relationships Consider Other Information

Brainstorming Session Allow junior members to benefit from senior members Allow more seasoned personnel a fresh set of eyes Allows audit management to set the appropriate tone for the audit Emphasize possibility of fraud existing in any audit

Specific Risks Improper Revenue Recognition Management Override of Internal Controls

Study Break 1. Audit risk is set according to: A.AICPA guidelines B.Audit firm policy C.SEC regulations D.GAAS B. Audit firm policy

Study Break 2. Which of the following is not a component of the fraud triangle? A.Adequate training B.Opportunity C.Rationalization D.Incentives A. Adequate training

Study Break 3. All of the following are objectives of a brainstorming session except: A.Allow management to set the tone B.Allow for junior members to benefit from senior members C.Allow for a fresh outlook on situation D.Allow for identification of actual occurrences of fraud

Audit Risk Model 3 Components of Audit Risk – Inherent Risk – Control Risk – Detection Risk Illustrating the Model – AR = IR x CR x DR Expanded Audit Risk Model – AR = IR x CR x AP x TD

Risk Components Matrix

Assessing the Components of Audit Risk Inherent Risk Control Risk Detection Risk

Inherent Risk Inherent Risk Defined Assessing Inherent Risk Identifying Significant Inherent Risks

Control Risk Control Risk Defined Assessing Control Risk – Planned assessed level of control risk – Actual assessed level of control risk

Detection Risk Detection Risk Defined Assessing Detection Risk – Planned acceptable level of detection risk

Interrelationships among Materiality, Detection Risk, and Substantive Audit Evidence

Components of Preliminary Audit Strategies Assessed level of inherent risk Planned assessed level of control risk Planned assessed level of analytical procedures risk Planned level of tests of details

Three Basic Preliminary Audit Strategies Response to Lower Inherent Risks A Lower Assessed Level of Control Risk A Primary Substantive Approach

Preliminary Audit Strategies and the Audit Risk Model

Preliminary Audit Strategy Comparison

Study Break 4. Which of the following is the correct audit risk model? A.AR = IR x CR x DR B.IR = AR x CR x DR C.CR = IR x AR x DR D.DR = CR x IR x AR A. AR = IR x CR x DR

Study Break 5. ______ is the risk that a material misstatement could occur and will not be prevented or detected by the entity’s internal controls. A.Inherent Risk B.Audit Risk C.Control Risk D.Detection Risk C. Control Risk

Study Break 6. The components of preliminary audit strategies include all of the following except: A.Assessed level of inherent risk B.Planned assessed level of control risk C.Actual assessed level of control risk D.Planned assessed level of analytical procedures risk C. Actual assessed level of control risk