Chapter 7 Assessing the Risk of Material Misstatement

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Chapter 7 Assessing the Risk of Material Misstatement - 1

Chapter 7 Assessing the Risk of Material Misstatement - 1

Audit Risk • Auditors accept some level of risk or uncertainty in performing the

Audit Risk • Auditors accept some level of risk or uncertainty in performing the audit function. • Assessing and managing risk is the key to conducting a quality audit. • The overall goal • If risk is pervasive, adjustments to strategy could be: Assessing the Risk of Material Misstatement - 2

Risk Assessment Procedures • During the risk assessment process, the auditor performs the following

Risk Assessment Procedures • During the risk assessment process, the auditor performs the following types of risk assessment procedures: Assessing the Risk of Material Misstatement - 3

Identification of Significant Risks • A significant risk represents an identified and assessed risk

Identification of Significant Risks • A significant risk represents an identified and assessed risk that, in the auditor’s professional judgment, requires special audit consideration. • Remember CAS 315 - Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and Its Environment • Per CAS 315, the auditor is required to consider all of the following: Assessing the Risk of Material Misstatement - 4

Considering Fraud Risk CAS 240 - The Auditor's Responsibilities Relating to Fraud in an

Considering Fraud Risk CAS 240 - The Auditor's Responsibilities Relating to Fraud in an Audit of Financial Statements The auditor is required to perform a fraud risk assessment, which involves: 1. Discuss with audit team members 2. Make inquiries to management, those in charge of governance, and others 3. Evaluate unusual/unexpected relationships 4. Evaluate the risk for revenue fraud Assessing the Risk of Material Misstatement - 5

Discussions Among Audit Team • CAS 240 requires the audit team to discuss: –

Discussions Among Audit Team • CAS 240 requires the audit team to discuss: – How and where financial statements – How anyone might – How the auditor might respond Assessing the Risk of Material Misstatement - 6

Inquiries of Management, Those in Charge of Governance, and Others • CAS 240 requires

Inquiries of Management, Those in Charge of Governance, and Others • CAS 240 requires the auditor to make specific inquiries about fraud in every audit. • Moreover, management and employees' responses to the auditor’s question Assessing the Risk of Material Misstatement - 7

 • The auditor’s inquiries of management should address • Auditors should also inquire

• The auditor’s inquiries of management should address • Auditors should also inquire about management’s process of • CAS 240 also requires the auditor to make inquiries of others within the entity • Throughout the audit, inquiries of executives and a wide variety of other employees Assessing the Risk of Material Misstatement - 8

Conditions for Fraud 1. Incentives/pressures. – Management or other employees 2. Opportunities. – Circumstances

Conditions for Fraud 1. Incentives/pressures. – Management or other employees 2. Opportunities. – Circumstances provide opportunities for management or employees Assessing the Risk of Material Misstatement - 9

3. Attitudes/rationalization. – The attitude of top management toward financial reporting Assessing the Risk

3. Attitudes/rationalization. – The attitude of top management toward financial reporting Assessing the Risk of Material Misstatement - 10

Responding to the Risks of Material Misstatement Due to Fraud • When the auditor

Responding to the Risks of Material Misstatement Due to Fraud • When the auditor identifies risks of material misstatements due to fraud, CAS 240 requires • Three levels of response: – Overall responses, – Responses at the assertion level – Responses related to management override. Assessing the Risk of Material Misstatement - 11

Audit Risk Model • Audit risk is the risk that AAR = IR x

Audit Risk Model • Audit risk is the risk that AAR = IR x CR x DR AAR = acceptable audit risk (AR) IR = inherent CR = control risk DR = detection risk Assessing the Risk of Material Misstatement - 12

Assessing Acceptable Audit Risk Acceptable audit risk To assess acceptable audit risk, the auditor

Assessing Acceptable Audit Risk Acceptable audit risk To assess acceptable audit risk, the auditor will first consider factors related to engagement risk Need to consider: The degree to which external users Is this a purchase Is there a prospectus What is the likelihood that a client will have financial difficulties Assessing the Risk of Material Misstatement - 13

Inherent Risk • When assessing the risk of material misstatement one component is inherent

Inherent Risk • When assessing the risk of material misstatement one component is inherent risk. – Inherent risk – The auditor’s is assessing the susceptibility to material misstatement – IF IR = 30%. Assessing the Risk of Material Misstatement - 14

Control Risk • The risk of material misstatement is also a function of: –

Control Risk • The risk of material misstatement is also a function of: – Control risk § The risk that the client’s system of internal does not prevent or detect error, on a timely basis. § The auditor’s assessment of the risk that a material misstatement could occur § IF CR = 20% Assessing the Risk of Material Misstatement - 15

Detection Risk • Finally, risk of material misstatement is additionally function of: – Detection

Detection Risk • Finally, risk of material misstatement is additionally function of: – Detection risk – Thus the risk that the audit evidence for an audit assertion § Detection risk is inversely proportional to the amount of evidence Assessing the Risk of Material Misstatement - 16

Table 7 -3 Reference for Evaluation of Risk Revenue Cycle Acquisitions and Payment Cycle

Table 7 -3 Reference for Evaluation of Risk Revenue Cycle Acquisitions and Payment Cycle Payroll Cycle Inventory Cycle Capital Acquisition and Repayment Cycle Acceptable Audit Risk (Willingness to permit material misstatement to exist after completing the audit) Low willingness Low willingness Inherent Risk (Assessment of material misstatement before considering internal controls) Medium Expect some misstatements High Expect many misstatements Low Expect few misstatements Control Risk (Assessment of effectiveness of internal controls) Medium (Moderate) Low (High) High (Ineffective) Medium (Moderate) Detection Risk (Extent of substantive testing) Medium (Medium level) High (Low level) Low (High level) Medium (Medium level) As a guideline: Low = 20% Moderate = 50% High = 80 to 100% Assessing the Risk of Material Misstatement - 17

Factors Affecting Acceptable Audit Risk: Degree External Users Rely on the Financial Statements •

Factors Affecting Acceptable Audit Risk: Degree External Users Rely on the Financial Statements • Indicators of the degree to which external users rely on the financial statements: – Client’s size: – Distribution of ownership: – Nature and amount of liabilities: • If there is extensive use of the financial statements Assessing the Risk of Material Misstatement - 18

Factors Affecting Acceptable Audit Risk: Likelihood of Financial Difficulty After Issue of Audit Report

Factors Affecting Acceptable Audit Risk: Likelihood of Financial Difficulty After Issue of Audit Report • Certain factors are good indicators of doubt of continuance as a going concern: • What does this mean? • Factors: Assessing the Risk of Material Misstatement - 19

Factors Affecting Acceptable Audit Risk: The Auditor’s Evaluation of Management Integrity • If a

Factors Affecting Acceptable Audit Risk: The Auditor’s Evaluation of Management Integrity • If a client has questionable integrity • Companies with low integrity often conduct business affairs – • Assessment of management integrity • How can you trust management? Assessing the Risk of Material Misstatement - 20

Assessing Inherent Risk • The inclusion of inherent risk in the audit risk model

Assessing Inherent Risk • The inclusion of inherent risk in the audit risk model is one of the most important concepts in auditing. Assessing the Risk of Material Misstatement - 21

Assessing Inherent Risk • Factors affecting inherent risk: – – – – Nature of

Assessing Inherent Risk • Factors affecting inherent risk: – – – – Nature of the client’s business Results of previous audits Related parties Complex or nonroutine transactions Judgment required to correctly record account balances and transactions Makeup of the population Factors related to fraudulent financial reporting and misappropriation of assets – Management motivation and biases – Initial versus repeat engagement Assessing the Risk of Material Misstatement - 22

Relationship of Risks to Evidence and Factors Influencing Risks • Auditors respond to risk

Relationship of Risks to Evidence and Factors Influencing Risks • Auditors respond to risk primarily by • In addition to modifying audit evidence (NET), there are two other ways auditors can change the audit to respond to risks: Assessing the Risk of Material Misstatement - 23

Audit Risk Model and Evidence Auditors develop various types of decision aids to help

Audit Risk Model and Evidence Auditors develop various types of decision aids to help link judgments affecting audit evidence with the appropriate evidence to collect. For example, the following table. Table 7 -5 Relationships of Audit Risk Model Components to Evidence Situation Acceptable Audit Risk Inherent Risk Control Risk Planned Detection Risk Amount of Evidence Required 1 High Low 2 Low Low Medium 3 Low High 4 Medium Medium 5 High Low Medium Assessing the Risk of Material Misstatement - 24

Consider the Audit Risk Model: DR = AR / (IR x CR) Use the

Consider the Audit Risk Model: DR = AR / (IR x CR) Use the following for risk assessments of IR and CR: Low = 20%, Moderate = 50%, High = 90% For Audit risk use: Low = 0. 02, Medium = 0. 03, High = 0. 05 Situation 2: AR = 0. 02 DR = 0. 01 / 0. 2 x 0. 2 = 0. 5, or 50%. This implies a medium amount of evidence as DR is moderate or medium Situation 3: AR = 0. 02 DR = 0. 02 / 0. 9 x 0. 9= 0. 25, or 25%. This is a low DR and thus a lot evidence. Situation 5: AR = 0. 05 DR = 0. 05 / 0. 2 x 0. 5 = 0. 5, or 50%. This implies a medium amount of evidence as DR is moderate or medium Assessing the Risk of Material Misstatement - 25

Materiality and the Audit Risk Model • Materiality and the Audit Risk Model: –

Materiality and the Audit Risk Model • Materiality and the Audit Risk Model: – The concepts of materiality and audit risk § are closely related and inseparable. – Risk is a measure of uncertainty § whereas materiality is a measure of magnitude or size. – Thus together they measure § the uncertainty of amounts of a given magnitude. Assessing the Risk of Material Misstatement - 26

Problem 7 -25, 14 th. Edition The audit staff have recently completed risk assessment

Problem 7 -25, 14 th. Edition The audit staff have recently completed risk assessment procedures to gain an understanding of Chocolate From Heaven Inc. ’s (CFHI) business and to identify risk factors relevant to the risk of material misstatement. (For further background refer to Question 6 -42. ) a. For each risk factor below, decide whether each piece of information would fit into your assessment of inherent (IR) or control risk (CR), and whether it would increase or decrease the specified risk. 1 Due to the size of the CFHI’s business, only one accounting clerk does most of the accounting. IR# IR$ CR# CR$ 2 In recent years here has been increased competition in the artisanal small batch chocolate business IR# IR$ CR# CR$ 3 The management bonuses at CFHI are based on net income. IR# IR$ CR# CR$ 4 All cheques require the signature of both owners. IR# IR$ CR# CR$ 5 Access to the warehouse at CFHI is restricted to warehouse employees only, who carry their own security cards. IR# IR$ CR# CR$ 6 The chocolate inventory has a one-year shelf life. IR# IR$ CR# CR$ 7 David Chan has developed a personal trusted relationship with each of the cocoa bean farmers in Tanzania, Ecuador, Philippines, and Honduras. He visits each farmer annually. He believes these strong relationships help to ensure farmers send CFHI high-quality beans. High-quality beans are critical to the production of high-quality chocolate. IR# IR$ CR# CR$ 8 CFHI just switched to an inventory tracking system that was developed by the owner’s son as part of a computer programming course. The project received an A grade. IR# IR$ CR# CR$ 9 CFHI customers include major retailers such as Target, Marshalls, and high-end grocery stores. One month before Christmas, a major selling time – representing approximately 30 percent of sales – IR# IR$ CR# CFHI’s custom-made cocoa butter press broke down. It took two weeks to obtain the necessary part to CR$ repair the machine. Orders were shipped to major retailers more than two weeks late and several are refusing to pay for the order, claiming that the delayed delivery resulted in a significant Assessing quantity of the Risk of Material Misstatement unsold chocolate. - 27

b. Assuming acceptable audit risk is low, for each situation specific to CFHI listed

b. Assuming acceptable audit risk is low, for each situation specific to CFHI listed below, assess the Inherent Risk and Control Risk. Determine an appropriate level of Detection Risk and the resulting level of evidence. Use High, Low, and Moderate for your assessments. Situation 1: Accuracy of recorded sales and valuation of receivables. CFHI sells goods to the United States and often transacts in US currency. The accounting clerk is inexperienced and not accustomed to recording foreign currency transactions. Audit risk (AR) = Inherent risk (IR) Control risk (CR) Detection risk (DR) Level of Evidence LOW RISK Situation 2: Existence of equipment. All equipment is highly specialized and extremely large. For safety reasons, the equipment is also bolted to the floor in the warehouse. CFHI purchases new equipment once every three to four years. All purchases are authorized by David (the owner). Cheques are signed by both owners after completing a review of the supporting documents. Audit risk (AR) = Inherent risk (IR) Control risk (CR) Detection risk (DR) Level of Evidence LOW RISK Assessing the Risk of Material Misstatement - 28

Situation 3: Existence of finished goods chocolate inventory. Finished goods are kept in a

Situation 3: Existence of finished goods chocolate inventory. Finished goods are kept in a locked area of the warehouse. Access to finished goods is restricted to warehouse employees only, who carry their own security cards. A video surveillance system monitors the finished goods area. The audit team has verified that the security system is working and has been operating throughout the year. (Refer to Risk Factors 6 and 9 in part (a) to assist in the assessment of inherent risk. ) Audit risk (AR) = Inherent risk (IR) Control risk (CR) Detection risk (DR) Level of Evidence LOW RISK Assessing the Risk of Material Misstatement - 29

Problem 7 -30, 14 th. Edition. You are the auditor in charge of the

Problem 7 -30, 14 th. Edition. You are the auditor in charge of the audit of the municipality of Sackville, New Brunswick. The municipality has a budget of about $65 million and has had a balanced budget for the last three years. There about ten people in the accounting office and the rest of the employees are operational, dealing with supervision of roadwork, garbage collection, and similar matters. Many services are outsourced, minimizing the need for employees. The municipality has a chief executive officer and a controller and reports to the council of elected representatives. REQUIRED For each of the following situations, state a preliminary conclusion for acceptable audit risk, inherent risk, control risk, and detection risk. Justify your conclusions. State any assumptions that are necessary for you to reach your conclusions. 1. This is the first year that you have been auditing Sackville. There has been extensive turnover after the recent election. Costs are out of control, and it looks like it may be necessary to raise realty taxes by as much as 15 percent. 2. For four years now, you have been auditing Sackville. The employees are experienced, and any control recommendations that you have suggested have been discussed and, where feasible, implemented. There is a tiny budget surplus this year, and it looks as if a balance budget is in sight again for next year. 3. Sackville is being hit by bad press. It seems that one of the purchasing agents set up a fictitious company and was billing the municipality for goods that had not been received. To make it worse, the purchasing agent’s wife was the assistant accountant. The office of the provincial auditor general has sent a letter to the controller of Sackville stating that the municipality has been selected for audit by the provincial auditor general’s office based on a random sample, and that the provincial auditors will be arriving within two weeks of the completion of your audit. Assessing the Risk of Material Misstatement - 30

Problem 7 -32, 14 th. Edition Following are six situations that involve the audit

Problem 7 -32, 14 th. Edition Following are six situations that involve the audit risk model as it is used for planning audit evidence requirements. REQUIRED a. Explain what low, medium and high mean for each of the four risks and planned evidence. b. Fill in the blanks for planned detection risk using the terms low, medium, and high. c. Using your knowledge of the relationship among the foregoing factors, state the effect on planned evidence (increase or decrease) of changing each of the following five factors, while the other three remain constant. a. An increase in acceptable audit risk. b. An increase in control risk. c. An increase in planned detection risk. d. An increase in inherent risk. e. An increase in inherent risk and a decrease in control risk of the same amount. Situation Risk 1 2 3 4 5 6 Acceptable audit risk High Low High Medium Inherent risk Low High Low Medium Control risk Low High Medium Planned detection risk - - - Planned evidence - - - Assessing the Risk of Material Misstatement - 31