CHAPTER 5 Audit Risk

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CHAPTER 5 Audit Risk Materiality
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The phrase reasonable assurance in the audit
report indicates that there is some audit risk.
Scope paragraph We conducted our audits in
accordance with generally accepted auditing
standards. Those standards require that we plan
and perform the audit to obtain reasonable
assurance about whether the financial statements
are free of material misstatement...
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Scope paragraph We conducted our audits in
accordance with generally accepted auditing
standards. Those standards require that we plan
and perform the audit to obtain reasonable
assurance about whether the financial statements
are free of material misstatement...
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What is materiality?
Materiality is the magnitude of omitted or
misstated information that probably would have
made a difference in the judgment of someone
relying on that information (FASB 2).
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For each engagement, auditors typically establish
a preliminary judgment about materiality.
The preliminary judgment about materiality is the
maximum amount by which the auditor be- lieves
the statements could be misstated and still not
affect the decisions of reasonable users.
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For each engagement, auditors typically establish
a preliminary judgment about materiality.
- may be based on a firm-wide formula
considering profitability and/or total assets,
e.g., 6 of net income
adjusted according to auditor judgment
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How does the preliminary judgment about
materiality affect the volume of audit evidence?
A small materiality estimate will result in more
evidence.
A large materiality estimate will result in less
evidence.
Investigate mis- statements over 100.
Investigate misstate- ments over 10,000.
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factors affecting the preliminary judgment about
materiality
- materiality is strongly influenced by client
size
1000... peanuts
1000 - WOW!
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factors affecting the preliminary judgment about
materiality
- materiality is strongly influenced by client
size - multiple bases of materiality may be
appropriate FOR EXAMPLE The auditor may be
concerned that net income is not misstated by
100,000, and total assets is not misstated
by 300,000.
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factors affecting the preliminary judgment about
materiality
- materiality is strongly influenced by client
size - multiple bases of materiality may be
appropriate - an irregularity is considered more
ma- terial than an error of the same dollar
amount. WHY?
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factors affecting the preliminary judgment about
materiality
- materiality is strongly influenced by client
size - multiple bases of materiality may be
appropriate - an irregularity is considered more
ma- terial than an error of the same dollar
amount. - small differences from contractual
requirements may be material (e.g., ratios
related to debt agreements)
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factors affecting the preliminary judgment about
materiality
- multiple bases of materiality may be
appropriate - an irregularity is considered more
ma- terial than an error of the same dollar
amount. - small differences from contractual
requirements may be material (e.g., ratios
related to debt agreements) - immaterial amounts
may accumulate into a material amount
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Acceptable audit risk is the risk that the
auditor is willing to accept that an
unqualified opinion will be issued for
statements that are materially misstated.
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98
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98
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Achieved audit risk is the actual risk that the
state- ments are materially mis- stated after an
unqualified opinion has been issued.
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How do acceptable and achieved audit risk affect
the audit report?
lt
if
audit report is supported by the evidence
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How do acceptable and achieved audit risk affect
the audit report?
audit report is not supported by the evidence
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Risk is very difficult to quantify.
subjective
based on judgment
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How can an auditor reduce audit risk?
gather more evidence
audit risk
achieved risk
acceptable risk
evidence and cost
sufficient, competent
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Auditors may face additional audit risk because
of business risk i.e., the risk that the client
will have financial problems.
Auditors should consider
- degree to which users rely on the cli- ents
financial statements - likelihood that the client
will have fi- nancial difficulties after the
report has been issued - management integrity
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Audit Risk has 3 components which combine to make
the audit risk model (AU 312)
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Inherent Risk
- defined as the risk that material mis-
statements exist before considering the client
internal controls - some accounts, components,
cycles are inherently riskier than others
auditors must - identify
inherently risky areas - gather appropriate
evidence regarding those areas
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inherent risk considerations
- nature of clients business EXAMPLE Sallys
Clothing Boutique rents store space in a
house. What are the inherently risky accounts?
cash inventory
accounts payable
Sallys
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inherent risk considerations
- nature of clients business EXAMPLE Sallys
Clothing Boutique rents store space in a
house. What are the inherently less risky
accounts? fixed assets equity
Sallys
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inherent risk considerations
- nature of clients business - integrity of
management
more evidence
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inherent risk considerations
- nature of clients business - integrity of
management - client motivation to misstate the
finan- cial statements
Are management bonuses based on net income?
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inherent risk considerations
- nature of clients business - integrity of
management - client motivation to misstate the
finan- cial statements - results of previous
audits - accounts, components which had
material mis- statements in prior years should
be tested extensively in the current year
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inherent risk considerations
- nature of clients business - integrity of
management - client motivation to misstate the
finan- cial statements - results of previous
audits - initial vs. repeat engagements
Why are initial audit engagements
inherently riskier than repeats?
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Why are initial audit engagements
inherently riskier than repeats?
- during the initial engagement, the auditor is
not familiar with client systems, internal
controls, and personnel - during the initial
engagement, be- ginning balances must be
exten- sively examined
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inherent risk considerations
- nature of clients business - integrity of
management - client motivation to misstate the
finan- cial statements - results of previous
audits - initial vs. repeat engagements - related
parties - nonroutine transactions
Has GAAP been correctly applied?
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inherent risk considerations
- related parties - nonroutine transactions -
judgment required to correctly record
transactions - susceptibility to
defalcation Example CASH
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inherent risk considerations
- judgment required to correctly record
transactions - susceptibility to defalcation -
makeup of the population
Which is riskier?
average age of a/p, 45 days
average age of a/p, 15 days
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Audit Risk has 3 components which combine to make
the audit risk model (AU 312)
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Audit Risk has 3 components which combine to make
the audit risk model (AU 312)
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Audit Risk has 3 components which combine to make
the audit risk model (AU 312)
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Audit Risk has 3 components which combine to make
the audit risk model (AU 312)
Detection risk is the risk that material
misstate- ments will not be detected by the
auditor.
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Why does detection risk exist?
- the auditor samples (sampling risk) - the
auditor may select ineffective audit
procedures - the auditor may apply procedures
ineffectively - the auditor may incorrectly
evaluate the results of procedures
The last 3 reasons are nonsam- pling errors. The
risk of their oc- currence is nonsampling risk.
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Audit Risk has 3 components which combine to make
the audit risk model (AU 312)
Which of these components can the auditor
influence?
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Audit Risk has 3 components which combine to make
the audit risk model (AU 312)
detection risk

x
x
Which of these components can the auditor
influence?
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misstatements (inherently risky accounts are
better shots)
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misstatements detected by internal controls
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misstatements not detected by internal
controls (control risk)
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misstatements detected by auditors
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