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Chapter 3 Risk assessment and materiality. In this chapter you will understand the auditors requirements for client acceptance and continuance, understand the steps that are involved in the preliminary engagement activities, know what is required to establish an understanding with the client, know the types of information that are included in an engagement letter,...
Chapter Three Risk Assessment and Materiality McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Audit Risk The The risk risk that that an an auditor auditor expresses expresses an an inappropriate inappropriate audit audit opinion opinion when when the the financial financial statements statements are are materially materially misstated misstated Financial statement level McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Individual account balance or class of transactions level Auditor’s Business Risk Client and third party lawsuits An auditor’s exposure to financial loss and damage to professional reputation Negative publicity McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 The Audit Risk Model Risk that material misstatements exist Audit Risk = RMM× DR Detection risk: Risk that auditor will not detect misstatements • Inappropriate audit procedure • Fail to detect when using appropriate audit procedure • Misinterpreting audit results McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Non-sampling risk Sampling risk The Audit Risk Model Inherent risk and control risk: Risk that material misstatements exist Audit Risk = IR × CR × DR Detection risk: Risk that auditor will not detect misstatements • Inappropriate audit procedure • Fail to detect when using appropriate audit procedure • Misinterpreting audit results McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Non-sampling risk Sampling risk Using the Audit Risk Model Set Set aa planned planned level level of of audit audit risk risk such such that that an an opinion opinion can can be be issued issued on on the the financial financial statements statements Assess Assess risk risk of of material material misstatements misstatements Use Use the the audit audit risk risk equation equation to to solve solve for for the the appropriate appropriate level level of of detection detection risk: risk: AR = MRR × DR AR DR = MRR Auditors use this level of detection risk to design audit procedures that will reduce audit risk to an acceptable level McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Using the Audit Risk Model Set Set aa planned planned level level of of audit audit risk risk such such that that an an opinion opinion can can be be issued issued on on the the financial financial statements statements Assess Assess inherent inherent risk risk and and control control risk risk Use Use the the audit audit risk risk equation equation to to solve solve for for the the appropriate appropriate level level of of detection detection risk: risk: AR = IR × CR × DR AR DR = IR × CR Auditors use this level of detection risk to design audit procedures that will reduce audit risk to an acceptable level McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Using the Audit Risk Model McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Using the Audit Risk Model Qualitative Qualitative terms terms may may also also be be used used in in the the audit audit risk risk model model McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Using the Audit Risk Model Qualitative Qualitative terms terms may may also also be be used used in in the the audit audit risk risk model model McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Assessing the Risk of Material Misstatement Due to Error or Fraud Misappropriation of Assets Risk Factors for Misappropriation of Assets include: Access to assets Adverse employee management relationships Lack of inventory control Inadequate separation of duties McGraw-Hill/Irwin No mandatory vacation policy Sudden changes in employee behaviour © The McGraw-Hill Companies 2010 Personal financial pressures Small, valuable inventory items Employee disregard of internal control Auditor’s Response to the Risk Assessment McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Auditor’s Response to the Risk Assessment Significant risks require special audit considerations Non-routine or unsystematically processed transactions Fraud risk factors Highly complex transactions Revenue recognition Application of new accounting standards McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Significant transactions with related parties Significant accounting estimates Industry specific issues Significant transactions outside the normal course of business of the entity Evaluation of Audit Test Results At At the the completion completion of of the the audit, audit, the the auditor auditor should should consider: consider: 1 The The effect effect of of the the identified identified misstatements misstatements on on the the audit audit 2 Whether Whether the the uncorrected uncorrected misstatements misstatements cause cause the the financial financial statements statements to to be be materially materially misstated misstated McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Evaluation of Audit Test Results IfIf the the auditor auditor determines determines that that the the misstatement misstatement is is or or may may be be the the result result of of fraud, fraud, and and has has determined determined that that the the effect effect could could be be material, material, the the auditor auditor should: should: McGraw-Hill/Irwin Attempt Attempt to to obtain obtain audit audit evidence evidence to to determine determine whether, whether, in in fact, fact, material material fraud fraud has has occurred occurred and, and, ifif so, so, its its effect effect Consider Consider the the implications implications for for other other aspects aspects of of the the audit audit Discuss Discuss the the matter matter and and the the approach approach to to further further investigation investigation with with an an appropriate appropriate level level of of management management that that is is at at least least one one level level above above those those involved involved in in committing committing the the fraud fraud and and with with senior senior management management IfIf appropriate, appropriate, suggest suggest that that the the client client consult consult with with legal legal counsel counsel Consider Consider withdrawing withdrawing from from the the engagement engagement © The McGraw-Hill Companies 2010 Documentation of the Auditor’s Risk Assessment and Response The The auditor auditor should should document: document: Discussions Discussions among among engagement engagement personnel personnel Procedures Procedures performed performed to to identify identify and and assess assess the the risks risks of of material material misstatement misstatement due due to to fraud fraud Risks Risks of of identified identified material material misstatement misstatement due due to to fraud fraud and and aa description description of of the the auditor’s auditor’s response response to to the the risks risks Fraud Fraud risks risks or or other other conditions conditions that that result result in in additional additional audit audit procedures procedures The The nature nature of of the the communications communications about about fraud fraud made made to to management, management, those those charged charged with with governance, governance, and and others others The The basis basis for for the the auditor’s auditor’s conclusions conclusions about about the the reasonableness reasonableness of of accounting accounting estimates estimates that that give give rise rise to to significant significant risks risks McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Communications about Fraud Whenever Whenever the the auditor auditor has has found found evidence evidence that that aa fraud fraud may may exist, exist, that that matter matter should should be be brought brought to to the the attention attention of of an an appropriate appropriate level level of of management management Fraud Fraud involving involving senior senior management management and and fraud fraud that that causes causes aa material material misstatement misstatement of of the the financial financial statement statement should should be be reported reported directly directly to to those those charged charged with with governance governance The The auditor auditor should should reach reach an an understanding understanding with with those those charged charged with with governance governance regarding regarding the the expected expected nature nature and and extent extent of of communications communications about about misappropriations misappropriations perpetrated perpetrated by by lower-level lower-level employees employees McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Communications about Fraud The The disclosure disclosure of of fraud fraud to to parties parties other other than than the the client’s client’s senior senior management management and and those those charged charged with with governance governance ordinarily ordinarily is is not not part part of of the the auditor’s auditor’s responsibility responsibility and and ordinarily ordinarily would would be be precluded precluded by by the the auditor’s auditor’s ethical ethical and and legal legal obligations obligations of of confidentiality confidentiality IFAC IFAC Code Code of of Ethics Ethics for for Professional Professional Accountants Accountants provides provides guidance guidance on on circumstances circumstances where where auditors auditors should should disclose disclose confidential confidential information information or or when when such such disclosure disclosure may may be be appropriate appropriate McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Materiality Misstatements, Misstatements, including including omissions, omissions, are are considered considered to to be be material material ifif they, they, individually individually or or in in the the aggregate, aggregate, could could reasonably reasonably be be expected expected to to influence influence the the economic economic decisions decisions of of users users taken taken on on the the basis basis of of the the financial financial statements statements Judgements Judgements about about materiality materiality are are made made in in light light of of surrounding surrounding circumstances, circumstances, and and are are affected affected by by the the size size or or nature nature of of aa misstatement, misstatement, or or aa combination combination of of both both Materiality is not an absolute and it is not a black or white issue! Materiality is a matter of professional judgement McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Steps in Applying Materiality on an Audit Step Step 1: 1: Determine Determine Materiality Materiality and and Performance Performance Materiality Materiality for for the the Financial Financial Statements Statements Step Step 2: 2: Determine Determine Materiality Materiality and and Performance Performance Materiality Materiality for for Classes Classes of of Transactions, Transactions, Account Account Balances Balances or or Disclosures Disclosures Step Step 3: 3: Evaluate Evaluate audit audit findings findings McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Step – Determine Materiality and Performance Materiality for the Financial Statements The The quantitative quantitative benchmark benchmark for for materiality materiality may may be be aa percentage percentage of: of: •• Profit Profit before before taxes taxes from from continuing continuing operations operations •• Total Total assets assets •• Total Total revenues revenues •• Three Three year year average average profit profit McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 At At the the planning planning stage stage the the auditor auditor should should also also determine determine performance performance materiality materiality Performance Performance materiality materiality isis set set at at aa lower lower amount amount than than materiality materiality to to provide provide aa margin margin for for possible possible undetected undetected misstatements misstatements Step –Determine Materiality and Performance Materiality for Classes of Transactions, Account Balances or Disclosures •• Auditing Auditing standards standards require require that that the the auditor auditor in in the the specific specific circumstances circumstances of of the the entity entity determines determines lesser lesser amounts amounts than than materiality materiality for for the the financial financial statements statements as as aa whole whole for for particular particular classes classes of of transactions, transactions, account account balances balances or or disclosures disclosures •• For For the the purpose purpose of of establishing establishing the the scope scope of of audit audit procedures procedures the the auditor auditor may may also also find find itit appropriate appropriate to to determine determine performance performance materiality materiality for for classes classes of of transactions, transactions, account account balances, balances, or or disclosures disclosures •• The The specific specific policies policies and and procedures procedures of of individual individual audit audit firms firms may may differ differ in in allocating allocating materiality materiality to to individual individual elements elements of of financial financial statements statements McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Step – Evaluate Audit Findings When When the the audit audit evidence evidence is is gathered, gathered, the the auditor: auditor: •• Evaluates Evaluates ifif identified identified misstatements misstatements affect affect the the overall overall audit audit strategy strategy and and audit audit plan plan •• Communicates Communicates and and requests requests management management and and those those charged charged with with governance governance to to correct correct identified identified misstatements misstatements •• Evaluates Evaluates the the effect effect of of uncorrected uncorrected misstatements misstatements on on the the financial financial statements statements McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 Step – Evaluate Audit Findings McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 End of Chapter McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 ... McGraw-Hill Companies 2010 Non-sampling risk Sampling risk The Audit Risk Model Inherent risk and control risk: Risk that material misstatements exist Audit Risk = IR × CR × DR Detection risk: Risk. .. levelof ofrisk riskactually actuallywas was Preliminary Assessment Level of Risk McGraw-Hill/Irwin © The McGraw-Hill Companies 2010 +/– Actual or Achieved Level of Risk The Auditor’s Risk Assessment. .. statements statements Assess Assess inherent inherent risk risk and and control control risk risk Use Use the the audit audit risk risk equation equation to to solve solve for for the the