Chapter 4Chapter 4

Risk AssessmentRisk Assessment

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Audit RiskAudit Risk

The risk that an auditor expresses an unqualified opinion on materially

misstated financial statements.

The risk that an auditor expresses an unqualified opinion on materially

misstated financial statements.

Financial statementlevel

Individual accountbalance or class

of transactions level

LO# 1

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The Audit Risk ModelThe Audit Risk Model

Audit Risk = IR × CR × DR

Inherent risk and control risk:Risk of material misstatement

Nonsamplingrisk

Nonsamplingrisk

Samplingrisk

Samplingrisk

Detection risk:Risk that auditor will not detect misstatements

Inappropriate audit procedure Fail to detect when using appropriate audit procedure Misinterpreting audit results

LO# 2

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Engagement RiskEngagement Risk

An auditor’s exposureto financial loss and

damage toprofessional reputation.

Client and thirdparty lawsuits

Negativepublicity

LO# 2

Local auditfailure …

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Using the Audit Risk ModelUsing the Audit Risk Model

Set a planned level of audit risk such that an opinion can be issued on the financial statements.

Assess the risk of material misstatement (IR x CR).

Use the audit risk equation to solve for the appropriate level of detection risk:

Set a planned level of audit risk such that an opinion can be issued on the financial statements.

Assess the risk of material misstatement (IR x CR).

Use the audit risk equation to solve for the appropriate level of detection risk:

AR = IR × CR × DR

DR = AR

IR × CR

Auditors use this level of detection risk to design audit procedures that will reduce audit risk to an acceptable level.

LO# 3

4-5

Limitations of theLimitations of theAudit Risk ModelAudit Risk Model

PreliminaryAssessmentLevel of Risk

Actualor AchievedLevel of Risk

LO# 3

+ / –

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.

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.

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The Auditor’s Risk Assessment ProcessThe Auditor’s Risk Assessment ProcessFigure 4-2Figure 4-2 An Overview of the Auditor’s Assessment of Business Risks and the Risk of An Overview of the Auditor’s Assessment of Business Risks and the Risk of

Material MisstatementsMaterial Misstatements

LO# 4

4-7

Errors are Errors are unintentional misstatementsunintentional misstatements:: Mistakes in gathering or processing financial data used Mistakes in gathering or processing financial data used

to prepare financial statements.to prepare financial statements. Unreasonable accounting estimates arising from Unreasonable accounting estimates arising from

oversight or misinterpretation of facts.oversight or misinterpretation of facts. Mistakes in the application of accounting principles Mistakes in the application of accounting principles

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

Errors are Errors are unintentional misstatementsunintentional misstatements:: Mistakes in gathering or processing financial data used Mistakes in gathering or processing financial data used

to prepare financial statements.to prepare financial statements. Unreasonable accounting estimates arising from Unreasonable accounting estimates arising from

oversight or misinterpretation of facts.oversight or misinterpretation of facts. Mistakes in the application of accounting principles Mistakes in the application of accounting principles

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

LO# 5

Assessing the Risk of Material Assessing the Risk of Material Misstatement Due to Error or FraudMisstatement Due to Error or Fraud

4-8

Fraud involves Fraud involves intentionalintentional misstatementsmisstatements. The fraud risk . The fraud risk identification process includes:identification process includes: Sources of information about possible Sources of information about possible

fraud―fraud― Communications among the audit teamCommunications among the audit team Inquires of management and othersInquires of management and others Analytical proceduresAnalytical procedures Unexpected period-end adjustmentsUnexpected period-end adjustments

Fraud involves Fraud involves intentionalintentional misstatementsmisstatements. The fraud risk . The fraud risk identification process includes:identification process includes: Sources of information about possible Sources of information about possible

fraud―fraud― Communications among the audit teamCommunications among the audit team Inquires of management and othersInquires of management and others Analytical proceduresAnalytical procedures Unexpected period-end adjustmentsUnexpected period-end adjustments

LO# 6

Assessing the Risk of Material Assessing the Risk of Material Misstatement Due to Error or FraudMisstatement Due to Error or Fraud

4-9

Three conditions usuallyexist when fraud occurs.

Three conditions usuallyexist when fraud occurs.

Incentive orpressure to

perpetrate fraud

Incentive orpressure to

perpetrate fraud

Opportunityto carry out

the fraud

Opportunityto carry out

the fraud

Attitude orrationalizationto justify fraud

Attitude orrationalizationto justify fraud

LO# 6

Assessing the Risk of Material Misstatement Assessing the Risk of Material Misstatement Due to Error or FraudDue to Error or Fraud

(Fraud Triangle)(Fraud Triangle)

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AuditorAuditor’’s Response tos Response tothe Risk Assessment (See Figure 4-3)the Risk Assessment (See Figure 4-3)

Financial statement level risks

Develop an overallresponse.

Determine what can go wrongat the account or assertion level.

LO# 7

Assess the risk of material misstatement at the financial statement and assertion levels.

Do theserisks relate

pervasively to the financialstatements?

Design audit procedures for

assertion level risks.

Assertion level risks

Yes

No

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Evaluation of AuditEvaluation of AuditTest ResultsTest Results

At the completion of the audit, the auditor should consider: 1. Whether the accumulated results of audit procedures affect the

assessments of the entity’s business risk and the risk of material misstatement, and

2. Whether the total misstatements cause the financial statements to be materially misstated.

THEN …

If the financial statements are materially misstated, the auditor should 1. Request management to eliminate the material misstatement, or 2. If management does not make needed adjustments, the auditor

should issue a qualified or adverse opinion.

At the completion of the audit, the auditor should consider: 1. Whether the accumulated results of audit procedures affect the

assessments of the entity’s business risk and the risk of material misstatement, and

2. Whether the total misstatements cause the financial statements to be materially misstated.

THEN …

If the financial statements are materially misstated, the auditor should 1. Request management to eliminate the material misstatement, or 2. If management does not make needed adjustments, the auditor

should issue a qualified or adverse opinion.

LO# 8

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Documentation of theDocumentation of theAuditor’s Risk AssessmentAuditor’s Risk Assessment

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 auditor’s 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, the audit committee, and others.

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 auditor’s 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, the audit committee, and others.

LO# 9

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Communications about FraudCommunications 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 the audit committee of the board of directors.

The auditor should reach an understanding with the audit committee regarding the expected nature and extent of communications about misappropriations perpetrated by lower-level employees.

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 the audit committee of the board of directors.

The auditor should reach an understanding with the audit committee regarding the expected nature and extent of communications about misappropriations perpetrated by lower-level employees.

LO# 10

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End of Chapter 4End of Chapter 4

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