Chapter 7 Planning the Audit: Identifying and Responding to the Risks of Material Misstatement. Learning Objectives. Define the concept of material misstatement and discuss the importance of materiality judgments in the audit context - PowerPoint PPT Presentation
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A U D I T I N GA RISK-BASED APPROACH TO
CONDUCTING A QUALITY AUDIT
9th Edition
Karla M. Johnstone | Audrey A. Gramling | Larry E. Rittenberg
7. Respond to the assessed risks of material misstatement and plan the procedures to be performed on an audit engagement
8. Apply the frameworks for professional decision making and ethical decision making to issues involving materiality, risk assessment, and risk responses
PROFESSIONAL JUDGMENT IN CONTEXT - Risks Associated with Financial Statement Misstatements
• Risk: Expresses uncertainty about events and/or their outcomes having a material effect on the organization• According to ISA 315 the risks:• Are associated with operational and financial reporting
decisions• Are sometimes hard to quantify and are judgmental in nature• Are present but the organization does not have material
misstatements, thus making it difficult for auditors to know when a risk factor truly is leading to a material misstatement for their particular clients
PROFESSIONAL JUDGMENT IN CONTEXT - Risks Associated with Financial Statement Misstatements
• What conditions would cause these types of risks to lead to a material misstatement in the financial statements? (LO 1, 2, 3, 4, 5)• What types of risks do these examples represent?
(LO 2, 3, 4)• How do these risks affect detection risk and audit
risk? (LO 2, 7)
Define the concept of material misstatement and discuss the importance of materiality judgments in
• Misstatement: An error, either intentional or unintentional, that exists in a transaction or financial statement account balance• Essential to understand materiality in the context of
• Performance materiality: Amount set by auditor at less than materiality level for financial statements as a whole or for particular classes of transactions, account balances, or disclosures• Used to:• Assess risks of material misstatement• Determine the nature, timing, and extent of audit
• Tolerable misstatement: Amount of misstatement in an account balance that the auditor could tolerate and still not judge underlying account balance to be materially misstated• Clearly trivial amount (posting materiality)• Inconsequential, whether:• Taken individually or in the aggregate • Judged by any criteria of size, nature, or circumstances
• Qualitative reasons for considering quantitatively small misstatement material• Hiding failure to meet analysts’ consensus expectations• Changing a loss into income, or vice versa• Concerning a segment playing significant role in
operations or profitability• Affecting compliance with regulatory requirements• Affecting compliance with loan covenants• Effecting the increases in management’s compensation
Situations necessitating Change in Materiality Judgments
• Initial materiality judgments were based on estimated or preliminary financial statement amounts, which are different from the audited amounts• Financial statement amounts initially used in the
Auditing in Practice - What Makes a Risk Significant?
• AU-C 315:• Whether the risk is a risk of fraud• Whether the risk is related to recent significant economic,
accounting, or other developments and, requires specific attention• Complexity of transactions• Whether the risk involves transactions with related parties• Degree of subjectivity in measurement of financial information
related to risk• Whether the risk involving significant transactions outside
factors FOR assessment of inherent risk at the assertion level at a higher level
• Account represents an asset that can be easily stolen• Account balance made up of complex transactions• Account balance requires a high level of estimation
to value• Account balance subject to adjustments that are not
in the ordinary processing routine• Account balanced composed of a high volume of
• Inherent risk at financial statement level that affects business operations and potential outcomes of organizational activities• Factors affecting such risk • Overall economic climate• Technological changes• Competitor actions• Geographic locations of suppliers
factors For assessment of inherent risk of operations at higher level
• Alternative products, services, competitors, or providers posing a threat to current business• Significant supply chain risks• Complex production and delivery processes• Mature and declining industry• Inability to control costs with possibility of
unforeseen costs• Producing products that have multiple substitutes
Inherent Risk at Financial Statement Level - Financial Reporting Risks
• When assessing this risk, auditors consider all items on a company’s financial statements that are subjective and based on judgment• Inherent risk at the financial statement level is affected
by:• Competence and integrity of management• Potential incentives to misstate the financial statements
Sources of Information Regarding Management Integrity
• Predecessor auditor• Other professionals in business community• Other auditors within audit firm• News media and Web searches• Public databases• Preliminary interviews with management• Audit committee members• Inquiries of federal regulatory agencies• Private investigation firms
Auditing in Practice - an Example of Inherent Risk at Financial Statement Level
• Former CFO of Maxim Integrated Products was held liable for securities fraud for engaging in a scheme to backdate stock option grants• Aided Maxim’s failure to maintain accurate accounting
records, resulting in inaccurate financial reporting• Management integrity was a fundamental problem
leading to this fraud• Assessing management integrity is no easy task
• Relates to susceptibility that a misstatement will not be prevented or detected on a timely basis by internal control system• It’s assessment can be made at:• Overall financial statement level• Account or assertion level
• Growth of organization exceeding accounting system infrastructure• Disregard of regulations for prevention of illegal acts• No internal audit function, or lack of respect for
internal audit function by management• Weak design, implementation, and monitoring of
internal controls• Lack of supervision of accounting personnel
TECHNIQUES TO UNDERSTANDING MANAGEMENT’S RISK ASSESSMENT• Understand processes used by the board and
management to manage risk• Review risk-based approach used by internal audit
function with its director and audit committee• Interviewing management about:• Risk approach• Risk preferences• Risk appetite• Relationship of risk analysis to strategic planning
TECHNIQUES TO UNDERSTANDING MANAGEMENT’S RISK ASSESSMENT• Review outside regulatory reports • Review company policies and procedures• Review company compensation schemes • Review prior years’ work• Determine how management and board: • Monitor risk• Identify changes in risk• React to mitigate, manage, or control the risk
Use preliminary analytical procedures and brainstorming to identify areas of heightened risk of
• Trend analysis: Based on the history of changes in the account, year-to-year comparisons of:• Account balances• Graphic presentations• Analysis of financial data• Histograms of ratios• Projections of account balances
• Ratio analysis: Identifies significant differences between the client results and a norm or between auditor expectations and actual results• Identifies potential audit problems that may be found
• Carried out through a comparison of client data with expectations:• Based on industry data• Based on similar prior-period data• Developed from industry trends, client budgets, other
• A group discussion designed to encourage auditors to creatively assess client risks• Particularly those relevant to possible existence of
fraud in an organization• Occur during the early planning phases of audit• Repeated if actual fraud is detected• Attended by entire engagement team and led by
• Assuming an account with simple transactions and well-trained personnel with no incentive to misstate financial statements• Inherent risk and control risk assessed at 50% and 20%
Planning Audit Procedures to Respond to the Assessed Risks of Material Misstatement
• Consider the role of internal controls, and determine whether control risk is relatively high or low• Obtain more relevant and reliable evidence with
increase in assessment of risk of material misstatement
• Types of audit procedures applied given the nature of account balance and relevant assertions regarding that account balance• Procedures • Assembling audit team with more experienced auditors• Including on audit team outside specialists• Increasing emphasis on professional skepticism
• When audit procedures are conducted and whether they are conducted at announced or predictable times• When risk of material misstatement is heightened• Audit procedures conducted closer to year end on an
unannounced basis• Some element of unpredictability included in timing
• Introducing unpredictability• Performance of some audit procedures on low risk
accounts, disclosures, and assertions• Change in timing of audit procedures from year to year• Selection of items for testing that are lower than prior-
year materiality• Performance of audit procedures on a surprise or
unannounced basis• Varying location or procedures year to year
• Amount of evidence that is necessary given client’s assessed risks, materiality, and level of acceptable audit risk• When risk of material misstatement is heightened,
auditor increases extent of audit procedures and demands more evidence