Lecture Auditing and assurance services (Second international edition) Chapter 3 Risk assessment and materiality

Chapter Three

Risk Assessment
and Materiality

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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

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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
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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

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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
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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.
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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.
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Using the Audit Risk Model

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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..

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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..

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Limitations of the Audit Risk Model
The
Theaudit
auditrisk
riskmodel

modelisisaaplanning
planningtool,
tool,but
butitithas
hassome
some
limitations
limitationsthat
thatmust
mustbe
beconsidered
consideredwhen
whenthe
themodel
modelisis
used
usedto
torevise
revisean
anaudit
auditplan
planor
orto
toevaluate
evaluateaudit
auditresults.
results.

••

The
The desired
desiredlevel
levelof
ofaudit
auditrisk
riskmay
maynot
notactually
actuallybe
be
achieved.
achieved.
•• ItItdoes
doesnot
notconsider
considerpotential
potentialauditor
auditorerror.
error.
•• There
Thereisisno
noway
wayof
ofknowing
knowingwhat
whatthe
thepreliminary
preliminary
level

levelof
ofrisk
riskactually
actuallywas.
was.
Preliminary
Assessment
Level of Risk
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+/–

Actual
or Achieved
Level of Risk


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.

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The Auditor’s Risk Assessment Process

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Understanding the Entity
and Its Environment
Industry
Factors

Accounting
policies

Regulatory
Environment

Objectives and
Strategies

Financial

Performance
Measures
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Nature of
the Entity

Business
Risks

Internal
Control


Understanding the Entity
and Its Environment

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Understanding the Entity
and Its Environment

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Auditor’s Risk Assessment Procedures
(How do we gather this evidence?)
Inquiries of
Management
and Others

Analytical
Procedures

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Observation
and Inspection


Assessing the Risk of Material
Misstatement Due to Error or Fraud
AA misstatement
misstatement due
due to
to error
error or
or fraud
fraud
is
is aa difference

difference between
between the
the amount,
amount,
classification,
classification, or
or presentation
presentation of
of aa
reported
reported financial
financial statement
statement element,
element,
account,
account, or
or item
item and
and the
the amount,
amount,
classification,
classification, or
or presentation
presentation
that
that would
would have
have
been

been reported
reported under
under the
the applicable
applicable
financial
financial reporting
reporting framework.
framework.
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Assessing the Risk of Material
Misstatement Due to Error or Fraud
Examples
Examples of
of misstatements
misstatements include:
include:









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An
Aninaccuracy
inaccuracyin
ingathering
gatheringor
or processing
processingdata
datafrom
from
which
which the
thefinancial
financialstatements
statementsare
areprepared.
prepared.
An
Anomission
omissionof
of an
anamount
amountor
or disclosure.
disclosure.
An
Anincorrect
incorrectaccounting
accountingestimate

estimatearising
arisingfrom
from
overlooking
overlookingor
orclear
clearmisinterpretation
misinterpretationof
offacts.
facts.
Management’s
Management’sselection
selectionand
andapplication
application of
of
accounting
accountingpolicies
policiesthat
that the
the auditor
auditorconsiders
considers
inappropriate
inappropriateor
or judgements
judgementsconcerning
concerning
accounting
accountingestimates

estimatesthat
that the
theauditor
auditor considers
considers
unreasonable,
unreasonable, including
includingrelated
relateddisclosures
disclosures..
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Assessing the Risk of Material
Misstatement Due to Error or Fraud
Errors
Errors are
are unintentional
unintentional misstatements:
misstatements:
 Mistakes
Mistakesin
ingathering
gatheringor
or processing
processingfinancial
financial

data
dataused

usedto
toprepare
preparefinancial
financialstatements.
statements.
 Unreasonable
Unreasonableaccounting
accountingestimates
estimatesarising
arising
from
fromoversight
oversight or
ormisinterpretation
misinterpretation of
of facts.
facts.
 Mistakes
Mistakesin
inthe
theapplication
applicationof
ofaccounting
accounting
policies
policiesrelating
relatingto
toamount,
amount, classification,
classification,

manner
mannerof
of presentation,
presentation, or
ordisclosure.
disclosure.

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Assessing the Risk of Material
Misstatement Due to Error or Fraud

Fraud
Fraudinvolves
involves
intentional
intentional misstatements.
misstatements.

Fraudulent
Fraudulent
financial
financial reporting
reporting

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Misappropriation
Misappropriation
of
ofassets
assets


Assessing the Risk of Material
Misstatement Due to Error or Fraud
Fraudulent
Fraudulent financial
financial reporting
reporting includes
includes acts
acts
such
such as
as the
the following:
following:
 Manipulation,
Manipulation,falsification,
falsification,or
or alteration
alterationof
of

accounting

accountingrecords
recordsor
or supporting
supportingdocuments
documents
used
usedto
toprepare
prepare financial
financial statements.
statements.
 Misrepresentation
Misrepresentationin,
in, or
or intentional
intentional omission
omission
from,
from,the
thefinancial
financial statements
statements of
of events,
events,
transactions,
transactions,or
orsignificant
significantinformation.
information.
 Intentional

Intentional misapplication
misapplicationof
of accounting
accountingpolicies
policies
relating
relatingto
toamount,
amount,classification,
classification,manner
mannerof
of
presentation,
presentation, or
or disclosure.
disclosure.

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Assessing the Risk of Material
Misstatement Due to Error or Fraud
Misappropriation
Misappropriation of
of assets
assets involves
involves the
the theft

theft
of
of an
an entity’s
entity’s assets
assets to
to the
the extent
extent that
that
financial
financial statements
statements are
are misstated.
misstated.
Examples
Examples include:
include:
Embezzling
cash received
Stealing
assets

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Paying for
goods and services
not received

Assessing the Risk of Material
Misstatement Due to Error or Fraud
Categorisation
Categorisationin
inevaluating
evaluatingmisstatements
misstatements
identified
identifiedduring
duringthe
theaudit
audit(ISA
(ISA450):
450):

•• Factual
Factualmisstatements
misstatementsare
aremisstatements
misstatementsabout
aboutwhich
which
there
thereisisno
nodoubt.
doubt.
•• Judgemental
Judgementalmisstatements

misstatementsare
aredifferences
differencesarising
arisingfrom
from
the
theselection
selectionor
orapplication
applicationof
ofaccounting
accountingpolicies
policiesthat
thatthe
the
auditor
auditorconsiders
considersinappropriate,
inappropriate,or
orthe
thejudgements
judgementsof
of
management
managementconcerning
concerningaccounting
accountingestimates
estimatesthat
thatthe
the

auditor
auditorconsiders
considersunreasonable.
unreasonable.
•• Projected
Projectedmisstatements
misstatementsare
arethe
theauditor’s
auditor’sbest
bestestimate
estimate
of
ofmisstatements
misstatementsininpopulations,
populations,involving
involvingthe
theprojection
projectionof
of
misstatements
misstatementsidentified
identifiedininaudit
auditsamples
samplesto
tothe
theentire
entire
populations
populationsfrom

fromwhich
whichthe
thesamples
sampleswere
weredrawn.
drawn.

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The Fraud Risk
Identification Process
Discussion
Discussion
among
among the
the
audit
audit team
team

Fraud
Fraud
risk
risk factors
factors

Inquiries

Inquiries of
of
management
management
and
and others
others

Sources of
information
Analytical
Analytical
procedures
procedures
Other
Other relevant
relevant
information
information

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