Chapter 4 Risk Assessment

LO# 1 Audit Risk The risk that an auditor expresses an inappropriate audit opinion when the financial statements are materially misstated. Financial statement level Individual account balance or disclosure level Assertion level 4-2

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 Ineffective audit procedures Whether the audit procedures were performed with due care 4-3

LO# 2 Engagement Risk Litigation An auditor’s exposure to financial loss and damage to professional reputation. Negative publicity 4-4

Using the Audit Risk Model: Quant approach LO# 3 Using the Audit Risk Model: Quant approach  Set a level of audit risk.  Assess the risk of material misstatement (IR x CR).  Use the audit risk equation to solve for the appropriate level of detection risk: Auditors use this level of detection risk to determine the needed audit resources. The lower the DR the greater the needed audit resources 4-5

Audit Risk Model: IR and CR verbal approach LO# 3 Audit Risk Model: IR and CR verbal approach Qualitative terms may also be used in the audit risk model

Audit Risk Model: RMM verbal approach (RMM is simply IR times CR) LO# 3 Audit Risk Model: RMM verbal approach (RMM is simply IR times CR) Qualitative terms may also be used in the audit risk model. 4-7

Limitations of the Audit Risk Model LO# 3 The audit risk model is a planning tool, but it has some limitations. A major limitation is that inherent risk and control risk are estimates, and you cannot know how accurate those estimates are. For example, the model may suggest that detection risk should be high (which means the amount of audit resources needed is low) when detection risk should be low (which means the amount of audit resources needed is high).

The Auditor’s Risk Assessment Process LO# 4 The Auditor’s Risk Assessment Process Auditors need to identify business risks and understand the potential misstatements that may result. Business risks are risks that result from significant conditions, events, circumstances or actions that impair management’s ability to execute strategies. 4-9

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 4-10

Auditor’s Risk Assessment Procedures (How do we gather this evidence?) LO# 4 Auditor’s Risk Assessment Procedures (How do we gather this evidence?) Inquiries of Management, Other Entity Personnel, and Others Outside the Entity Analytical Procedures Observation and Inspection 4-11

Understanding the Entity and Its Environment LO# 4 Understanding the Entity and Its Environment Nature of the Entity Industry, Regulatory, and External Factors Internal Control Objectives, Strategies, and Business Risks Entity Performance Measures 4-12

LO# 4 Nature of the Entity The sources of funding of the entity’s operations and investment activities, including the entity’s capital structure, noncapital funding, and other debt instruments. The sources of the entity’s earnings, including the relative profitability of key products and services. Key supplier and customer relationships. 4-13

Industry, Regulatory, and Other External Factors LO# 4 Industry, Regulatory, and Other External Factors 4-14

LO# 4 Understanding the Entity’s Objectives, Strategies, Risks and Risk Assessment Process Now, the Countrywide case will deepen our understanding of these things by focusing on one company. 4-15

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: 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. 4-16

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 is intentional. The fraud risk identification process includes: Sources of information about possible fraud― Brainstorming among the audit team Inquiries of management and others Analytical procedures 4-17

The Fraud Triangle Fraud Triangle Opportunity (weak internal control) LO# 6 The Fraud Triangle Incentive or motivation or pressure Opportunity (weak internal control) Fraud Triangle Attitude or Rationalization (bad ethics)

Fraudulent Financial Reporting LO# 6 Fraudulent Financial Reporting Risk Factors Relating to Incentive/Pressure include: Excessive pressure for management to meet third party expectations Financial stability or profitability is threatened Management’s personal financial situation is threatened 4-19

Risk Factors Relating to Attitudes/Rationalizations LO# 6 Risk Factors Relating to Attitudes/Rationalizations Fraudulent Financial Reporting Risk Factors Relating to Attitudes/Rationalizations include: Most difficult of the 3 corners of the fraud triangle to identify Weak or bad ethics on the part of management Corporate or personal Symptoms may - or may not - be present 4-20

Co. paying for goods and services not received by LO# 6 The auditing standards require auditors to be vigilant, not just re financial reporting fraud, but also re misappropriation of assets. Misappropriation of assets involves the theft of an entity’s assets to the extent that financial statements are misstated. Examples include: Stealing assets Co. paying for goods and services not received by the co. Embezzling cash 4-21

Assessing the Risk of Misappropriation of Assets LO# 6 Assessing the Risk of Misappropriation of Assets 4-22

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. 4-23

Auditor’s Response to the Risk Assessment LO# 7 To respond appropriately to financial statement level risks, the auditor may do the following: Emphasize to the audit team the need to maintain professional skepticism. Assign more experienced staff or those with specialized skills. Provide more supervision. Incorporate additional elements of unpredictability in the selection of audit procedures. 4-24 24

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. 4-25

Evaluation of Audit Test Results LO# 8 If the auditor determines that the misstatement is or may be the result of fraud, and has determined that the effect could be material, the auditor should: Attempt to obtain audit evidence to determine whether, in fact, material fraud has occurred and, if so, its effect. Consider the implications for other aspects of the audit. Discuss the matter and the approach to further investigation with an appropriate level of management that is at least one level above those involved in committing the fraud and with senior management. If appropriate, suggest that the client consult with legal counsel. Consider withdrawing from the engagement. 4-26

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. 4-27

Communications about Fraud LO# 10 If the auditor decides fraud may exist, it should be brought to the attention of management. Fraud involving senior management or that causes a material misstatement of the financial statements should be reported to the audit committee. As with Illegal Acts, if the company is publicly held, and does not promptly disclose a material misstatement of the financial statements to the SEC, the auditor must do so. The auditor must disclose fraud to a successor auditor. The auditor must disclose fraud if ordered to do so by a court (subpoena). 4-28

End of Chapter 4 4-29