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Chapter 3

Risk Assessment and Materiality

Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Audit Risk

The risk that an auditor will issue an

unqualified opinion on materially

misstated financial statements.

Financial statement

level

Individual account

balance or class

of transactions level

LO# 1

3-2

Engagement Risk

An auditor’s exposure

to financial loss and

damage to

professional reputation.

Client and third

party lawsuits

Negative

publicity

LO# 1

Local audit

failure …

3-3

The Audit Risk Model

Audit Risk = IR × CR × DR

Inherent risk and control risk:

Risk that material misstatements exist

Nonsampling

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

LO# 2

3-4

Using the Audit Risk Model

Set a planned level of audit risk such that an opinioncan be issued on the financial statements.

Assess inherent risk and control risk.

Use the audit risk equation to solve for the appropriatelevel 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.

LO# 3

3-5

Relationship of the Entity’s Business Risks to the

Audit Risk ModelFigure 3-1

LO# 3

3-6

Using the Audit Risk Model

Qualitative terms may also be used in the audit risk model.

Case AR IR CR DR

1 Very low High High Low

2 Low Low Moderate Moderate

3 Very low Low Low High

LO# 3

3-7

Limitations of the

Audit Risk Model

Preliminary

Assessment

Level of Risk

Actual

or Achieved

Level of Risk

LO# 4

+ / –

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.

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.

LO# 5

3-9

The Auditor’s Risk Assessment ProcessFigure 3-2 An Overview of the Auditor’s Assessment of Business Risks and the Risk of

Material Misstatements

LO# 5

3-10

Understanding the Entity

and Its Environment

Industry

Factors

Regulatory

Environment

Nature of

the Entity

Internal

Control

Objectives and

Strategies

Business

Risks

Performance

Measures

LO# 5

3-11


and Its Environment

LO# 5

3-12


and Its Environment

LO# 5

3-13

Auditor’s Risk Assessment Procedures

(How do we gather this evidence?)

Inquiries of

Management

and Others

Analytical

Procedures

Observation

and Inspection

LO# 5

3-14

Examples of misstatements include:

An inaccuracy in gathering or processing data from which financial statements are prepared.

A difference between the amount of a reported financial statement account and the amount that would have been reported under GAAP.

The omission of a financial statement element, account, or item.

An incorrect accounting estimate arising from an oversight or misinterpretation of facts.

The omission of information required to be disclosed in accordance with GAAP.

LO# 6

Assessing the Risk of Material

Misstatement Due to Error or Fraud

3-15

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.

LO# 6



3-16

Fraud involves intentionalmisstatements. The fraud risk identification process includes:

Sources of information about possible fraud

Communications among the audit team

Inquires of management and others

Fraud risk factors

Analytical procedures

Other information

LO# 6



3-17

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

LO# 6

Assessing the Risk of Material Misstatement

Due to Error or Fraud

(Fraud Triangle)

3-18

Financial stability

or profitability

is threatened

Excessive pressure

for management to

meet third party

expectations

Management’s personal

financial situation

is threatened

LO# 6

Fraudulent Financial Reporting

Risk Factors Relating to Incentive/Pressure include:



(See Table 3-4)

3-19

Ineffective

monitoring of

management

Nature

of the

industry

Deficient

internal

control

Complex

or unstable

organizational

structure

LO# 6


Risk Factors Relating to Opportunities include:



(See Table 3-5)

3-20

Risk Factors Relating to

Attitudes/Rationalizations

(See Table 3-6)

Poor communication

channels for reporting

inappropriate behavior

Weak ethical

standards for

Management

behavior

Committing to

aggressive or

unrealistic forecasts

Use of

inappropriate accounting

based on materiality

LO# 6


Risk Factors Relating to Attitudes/Rationalizations include:

3-21

Fraud involves

intentional misstatements.

Fraudulent

financial reporting

Misappropriation

of assets

LO# 6



3-22

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.

LO# 6



3-23

Misappropriation of assets involves the

theft of an entity’s assets to the extent that financial statements are misstated.

Examples include:

Stealing

assets

Embezzling

cash received

Paying for

goods and services

not received by

the company

LO# 6



3-24

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

LO# 6



Misappropriation of Assets

Risk Factors for Misappropriation of Assets include:

Employee

disregard

of internal

control3-25

Auditor’s Response to

the Risk Assessment (See Figure 3-3)

Financial statement level risks

Develop an overall

response.

Determine what can go wrong

at the account or assertion level.

LO# 7

Assess the risk of material misstatement at the financial statement and assertion levels.

Do

these

risks relate

pervasively

to the

financial

statements?

Design audit

procedures for

assertion level risks.

Assertion level risks

Yes

No

3-26

Auditor’s Response to the Risk

Assessment

LO# 7

To respond appropriately to pervasive financial statement risk, 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.

3-27

Evaluation of Audit

Test ResultsAt 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.

LO# 8

3-28

Evaluation of Audit

Test ResultsIf 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.

LO# 8

3-29

Documentation of the

Auditor’s Risk AssessmentThe 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.

LO# 9

3-30

Communications about FraudWhenever 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.

LO# 10

3-31

The disclosure of fraud to parties other than the client’s

senior management and its audit committee ordinarily is not

part of the auditor’s responsibility and ordinarily would be

precluded by the auditor’s ethical and legal obligations of

confidentiality, except when the following conditions exist:

To comply with certain legal and regulatory requirements.

To a successor auditor when the successor makes

inquiries in accordance with AU 315, Communications

between Predecessor and Successor Auditors.

In response to a subpoena.

To a funding agency or other specified agency in

accordance with requirements for the audits of entities

that receive governmental financial assistance.

LO# 10

Communications about Fraud

3-32

Materiality

The magnitude of an omission or misstatement of

accounting information that makes it probable that

the judgment of a reasonable person relying on

the information would be changed or influenced

by the omission or misstatement.

Materiality is not an absolute and

it is not a black or white issue!

The determination of materiality

requires professional judgment.

LO# 11

3-33

Steps in Applying Materiality

on an Audit

Step 1:

Determine a materiality level for the overall financial statements(planning materiality)

Step 2:

Determine tolerable misstatement (allocation of materiality at individual account/class of transactions

level)

Step 3:

Evaluate auditing findings(near the end of the audit)

LO# 12

3-34

Step 1 – Determine Overall

Materiality

The quantitative base formateriality is a percentage(typically 3-5 percent) of:

• Total revenues.

• Gross profit.

• Income before taxes.

• Income from continuingoperations.

• Total assets.

• Three year average income.

The quantitative amountsmay be adjusted lower forqualitative factors such as:

• Close to violating loancovenants.

• Break-even earnings.

• Management turnover.

• High market pressures.

• High fraud risk.

• Higher than normal riskof bankruptcy.

LO# 12

3-35

Step 2 –Determine Tolerable

MisstatementTolerable misstatement is the amount of planning

materiality allocated to an account or class of

transactions. Combined tolerable misstatement is

generally greater than planning materiality because:

Not all accounts will be misstated by their full

tolerable misstatement allocation.

Audits of individual accounts are conducted

simultaneously.

When errors are identified, additional testing is

typically performed in that account and related

accounts.

Overall materiality serves as a “safety net.”

LO# 12

3-36

Step 3 – Evaluate Audit

FindingsWhen the audit evidence is gathered, the auditor:

Aggregates misstatements from each account or

class of transactions (including known and likely

misstatements).

Considers the effect of misstatements not adjusted in

the prior period.

Compares the aggregate misstatement to planning

materiality.

If the aggregate misstatement is less than planning

materiality, the auditor can conclude that the financial

statements are fairly presented, if not, an adjustment

should be made.

LO# 12

3-37

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