Risk Assessment and Materiality

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Chapter Three

• Risk Assessment and Materiality

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Audit Risk
The risk that an auditor expresses an
inappropriate audit opinion when the financial
statements are materially misstated.
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Auditors Business Risk
An auditors exposureto financial loss
anddamage toprofessional reputation.
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The Audit Risk Model
Audit Risk RMM DR
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The Audit Risk Model
Audit Risk IR CR DR
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Using the Audit Risk Model
? Set a planned level of audit risk such that an
opinion can be issued on the financial
statements. ? Assess risk of material
misstatements. ? Use the audit risk equation to
solve for the appropriate level of detection
risk
AR MRR DR
Auditors use this level of detection risk to
design audit procedures that will reduce audit
risk to an acceptable level.
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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
AR IR CR DR
Auditors use this level of detection risk to
design audit procedures that will reduce audit
risk to an acceptable level.
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Using the Audit Risk Model
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Using the Audit Risk Model
Qualitative terms may also be used in the audit
risk model.
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Using the Audit Risk Model
Qualitative terms may also be used in the audit
risk model.
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Limitations of the Audit Risk Model

• 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.

Actual or Achieved Level of Risk
Preliminary AssessmentLevel of Risk
/
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The Auditors RiskAssessment Process
Auditors need toidentify business risks
andunderstand the potentialmisstatements
thatmay result.
Business risksinclude any external orinternal
factors, pressures, andforces that bear on the
entitysability to survive andbe profitable.
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The Auditors Risk Assessment Process
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Understanding the Entityand Its Environment
RegulatoryEnvironment
Nature ofthe Entity
IndustryFactors
BusinessRisks
Objectives and Strategies
Accounting policies
InternalControl
FinancialPerformance Measures
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Understanding the Entityand Its Environment
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Understanding the Entityand Its Environment
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Auditors Risk Assessment Procedures(How do we
gather this evidence?)
Inquiries of Managementand Others
Observationand Inspection
AnalyticalProcedures
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Assessing the Risk of Material Misstatement Due
to Error or Fraud

• A misstatement due to error or fraud is 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.

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Assessing the Risk of Material Misstatement Due
to Error or Fraud

• Examples of misstatements include
• An inaccuracy in gathering or processing data
  from which the financial statements are prepared.
• An omission of an amount or disclosure.
• An incorrect accounting estimate arising from
  overlooking or clear misinterpretation of facts.
• Managements selection and application of
  accounting policies that the auditor considers
  inappropriate or judgements concerning accounting
  estimates that the auditor considers
  unreasonable, including related disclosures.

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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
  policies relating to amount, classification,
  manner of presentation, or disclosure.

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Assessing the Risk of Material Misstatement Due
to Error or Fraud
Fraud involvesintentional misstatements.
Fraudulentfinancial reporting
Misappropriationof assets
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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 policies
  relating to amount, classification, manner of
  presentation, or disclosure.

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Assessing the Risk of Material Misstatement Due
to Error or Fraud

• Misappropriation of assets involves the theft
  of an entitys assets to the extent that
  financial statements are misstated. Examples
  include

Embezzlingcash received
Stealing assets
Paying forgoods and servicesnot received
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Assessing the Risk of Material Misstatement Due
to Error or Fraud

• Categorisation in evaluating misstatements
  identified during the audit (ISA 450)
• Factual misstatements are misstatements about
  which there is no doubt.
• Judgemental misstatements are differences arising
  from the selection or application of accounting
  policies that the auditor considers
  inappropriate, or the judgements of management
  concerning accounting estimates that the auditor
  considers unreasonable.
• Projected misstatements are the auditors best
  estimate of misstatements in populations,
  involving the projection of misstatements
  identified in audit samples to the entire
  populations from which the samples were drawn.

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The Fraud RiskIdentification Process
Discussionamong theaudit team
Inquiries ofmanagementand others
Sources of information
Fraudrisk factors
Analyticalprocedures
Other relevant information
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Assessing the Risk of Material Misstatement Due
to Error or Fraud (Fraud Triangle)
Three conditions usuallyexist when fraud occurs.
Incentive orpressure toperpetrate fraud
Opportunityto carry out the fraud
Attitude orrationalisationto justify fraud
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Assessing the Risk of Material Misstatement Due
to Error or Fraud (See Table 3-4)
Fraudulent Financial Reporting Risk Factors
Relating to Incentive/Pressure include
Financial stabilityor profitabilityis threatened
Managements personalfinancial situation is
threatened
Excessive pressurefor management tomeet third
partyexpectations
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Assessing the Risk of Material Misstatement Due
to Error or Fraud (See Table 3-5)
Fraudulent Financial Reporting Risk Factors
Relating to Opportunities include
Natureof theindustry
Complexor unstableorganisationalstructure
Ineffectivemonitoring ofmanagement
Deficientinternalcontrol
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Risk Factors Relating to Attitudes
/Rationalisations (See Table 3-6)
Fraudulent Financial Reporting Risk Factors
Relating to Attitudes/Rationalisations include
Poor communicationchannels for
reportinginappropriate behaviour
Use ofinappropriate accountingbased on
materiality
Committing to aggressive or unrealistic forecasts
Weak ethicalstandards for managementbehaviour
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Assessing the Risk of Material Misstatement Due
to Error or Fraud
Misappropriation of Assets Risk Factors for
Misappropriation of Assets include
Accessto assets
Personalfinancialpressures
Adverseemployee managementrelationships
Lack ofinventory control
No mandatory vacation policy
Small, valuableinventory items
Inadequateseparationof duties
Employee disregard of internal control
Sudden changes inemployee behaviour
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Auditors Response to the Risk Assessment
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Auditors Response to the Risk Assessment
Significant risks require special audit
considerations
Fraud risk factors
Significant accounting estimates
Non-routine or unsystematically processed
transactions
Highly complex transactions
Significant transactions with related parties
Revenue recognition
Industry specific issues
Significant transactions outside the normal
course of business of the entity
Application of new accounting standards
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Evaluation of Audit Test Results

• At the completion of the audit, the auditor
  should consider
• 1. The effect of the identified misstatements on
  the audit.
• 2. Whether the uncorrected misstatements cause
  the financial statements to be materially
  misstated.
• THEN
• 1. If the uncorrected misstatements are
  immaterial and the relevant qualitative aspects
  of the entitys accounting practices and
  financial statements presentation do not imply
  otherwise, the auditor can issue an unmodified
  opinion.
• 2. If the uncorrected misstatements are material,
  the audit should issue a qualified or adverse
  opinion.

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Evaluation of Audit Test Results

• 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.

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Documentation of the Auditors Risk Assessment
and Response

• 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 auditors 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 basis for the auditors conclusions about the
  reasonableness of accounting estimates that give
  rise to significant risks.

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Communications about Fraud
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 those charged with governance. The
auditor should reach an understanding with those
charged with governance regarding the expected
nature and extent of communications about
misappropriations perpetrated by lower-level
employees.
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Communications about Fraud
The disclosure of fraud to parties other than
the clients senior management and those charged
with governance ordinarily is not part of the
auditors responsibility and ordinarily would be
precluded by the auditors ethical and legal
obligations of confidentiality.
IFAC Code of Ethics for Professional Accountants
provides guidance on circumstances where auditors
should disclose confidential information or when
such disclosure may be appropriate.
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Materiality
Misstatements, including omissions, are
considered to be material if they, individually
or in the aggregate, could reasonably be expected
to influence the economic decisions of users
taken on the basis of the financial statements.
Judgements about materiality are made in light
of surrounding circumstances, and are affected by
the size or nature of a misstatement, or a
combination of both.
Materiality is not an absolute and it is not a
black or white issue! Materiality is a matter of
professional judgement.
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Steps in Applying Materialityon an Audit
Step 1 Determine Materiality and Performance
Materiality for the Financial Statements
Step 2 Determine Materiality and Performance
Materiality for Classes of Transactions, Account
Balances or Disclosures
Step 3 Evaluate audit findings
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Step 1 Determine Materiality and Performance
Materiality for the Financial Statements

• The quantitative benchmark for materiality may
  be a percentage of
• Profit before taxes from continuing
  operations.
• Total assets.
• Total revenues.
• Three year average profit.

At the planning stage the auditor should also
determine performance materiality. Performance
materiality is set at a lower amount than
materiality to provide a margin for possible
undetected misstatements.
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Step 2 Determine Materiality and Performance
Materiality for Classes of Transactions, Account
Balances or Disclosures

• Auditing standards require that the auditor in
  the specific circumstances of the entity
  determines lesser amounts than materiality for
  the financial statements as a whole for
  particular classes of transactions, account
  balances or disclosures.
• For the purpose of establishing the scope of
  audit procedures the auditor may also find it
  appropriate to determine performance materiality
  for classes of transactions, account balances, or
  disclosures.
• The specific policies and procedures of
  individual audit firms may differ in allocating
  materiality to individual elements of financial
  statements.

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Step 3 Evaluate Audit Findings

• When the audit evidence is gathered, the auditor
• Evaluates if identified misstatements affect the
  overall audit strategy and audit plan.
• Communicates and requests management and those
  charged with governance to correct identified
  misstatements.
• Evaluates the effect of uncorrected
  misstatements on the financial statements.

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Step 3 Evaluate Audit Findings
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End of Chapter 3