ch9-Assessing The Risk of Material Misstatement

An auditor who audits a business cycle that has low inherent risk should A) increase the amount of audit evidence gathered. B) assign more experienced staff to that area. C) expand planning procedures. D) do none of the above.

A

Acceptable audit risk

A measure of how much risk the auditor is willing to take that the financial statements may be materially misstated after the audit is completed and an unqualified audit opinion has been issued.

Control Risk

A measure of the auditor's assessment of the likelihood that misstatements exceeding a tolerable amount in a segment will not be prevented or detected by the client's internal controls.

Inherent risk

A measure of the auditor's assessment of the likelihood that there are material misstatements before considering the effectiveness of internal control

Planned detection risk

A measure of the risk that audit evidence for a segment will fail to detect misstatements exceeding a tolerable amount, should such misstatements exist.

D

AAR-PDR relationship

I

AAR-Planned audit evidence relationship

PDR =

AAR/IRxCR

Auditor controlled risk characeristics

Acceptable Audit Risk: Overall Account Level Planned Detection Risk: Substantive Audit Procedures

risk in auditing

Auditors accept some level of risk or uncertainty in performing audits.

ASSESSING ACCEPTABLE AUDIT RISK

Auditors must decide appropriate acceptable audit risk. Auditors must first decide engagement risk and use it to modify acceptable audit risk. Engagement risk is the risk that the auditor (or firm) will suffer harm after the audit is finished, even though the report was correct. Engagement risk is closely related to client business risk because the risk that the auditor will be sued is often related to business failure after the audit is finished.

acceptable audit risk

Auditors must first decide engagement risk and use it to modify ___

Based on audit evidence gathered and evaluated, an auditor decides to increase the assessed level of control risk from that originally planned. To achieve an overall audit risk level that is substantially the same as the planned audit risk level, the auditor would A) increase materiality levels. B) decrease detection risk. C) decrease substantive testing. D) increase inherent risk.

B

Risk of material misstatement at the assertion level A) is only relevant to account balances. B) determines the nature, timing, and extent of further audit procedures. C) refers to risks that are pervasive to the financial statements as a whole. D) consists of business risk and inherent risk.

B

presume that risks of fraud exist in revenue recognition

Because several high-profile cases of financial statement fraud involve misstatements in revenue recognition, auditing standards require the auditor to

When assessing risk, it is important to remember that A) for acceptable audit risk, the SEC decides the risk the CPA firm should take for public clients. B) inherent risk can be changed by the auditor. C) detection risk can only be determined after audit risk, inherent risk, and control risk are determined. D) control risk is determined by company management since they are responsible for internal control.

C

I

CR-PDR relationship

D

CR-Planned audit evidence relationship

Pervasive Factors

Competition Operating Difficulties Aggressive Management

An auditor who audits a business cycle that has low inherent risk should A) increase the amount of audit evidence gathered. B) assign more experienced staff to that area. C) expand planning procedures. D) do none of the above.

D

The auditor's consideration of fraud risk is made at both the

Financial statement level and Assertion level for classes of transactions, account balances, and presentation and disclosures.

Auditor Uncontrolled Risk Characteristic

IR & CR exist independently IR & CR are Assessed by the auditor (i.e., no ability to change) IR & CR may be assessed independently or collectively (Risk of Material Misstatement (RMM)) IR & CR assessment never eliminate substantive testing

I

IR-PDR relationship

D

IR-Planned audit evidence relationship

Risk of Material Misstatement at the Assertion Level

Inherent risk—Susceptibility of an assertion to material misstatement. Control risk—Risk that internal controls will not prevent or detect material misstatement.

Risk assessment procedures

Inquiries of management and others within the entity Analytical procedures Observation and inspection Discussion among engagement team members Other risk assessment procedures

magnitude

Materiality is a measure of

Factors to Consider when Assessing Inherent Risk

Nature of the client's business Results of previous audits Initial versus repeat engagement 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 Factors related to misappropriation of assets

Examples of significant risk

Nonroutine transactions, including related-party transactions, often represent significant risk. Account balances or transactions that require estimates for which significant measurement uncertainty exists also may require more attention

difficulty of measuring the components of the model

One major limitation in the application of the audit risk model is the ___. It is a highly subjective process, so most auditors use broad categories such as low, medium, and high.

AAR

PDR & Other Risks have direct relation with __

IR & CR

PDR & Other Risks have inverse relation with __

Evidence

PDR has an Inverse Relationship with

Assertion Specific Factors

Past Experience Susceptibility to Misappropriation Complexity or Subjectivity

I

Performance materiality-Planned audit evidence relationship

Control Risk Assessment

Planning CR Assessed CR Actual CR

Risk of Material Misstatement at the Overall Financial Statement Level

Refers to the risks that relate pervasively to the financial statements as a whole and potentially affect a number of different transactions and accounts

Relating Performance Materiality and Risks to Balance-Related Audit Objectives

Relating Performance Materiality and Risks to Balance-Related Audit Objectives

fraud or error

Risk assessment procedures include assessing the risk of material misstatement due to __

Uncertainty

Risk is a measure of

Permissible DR

Solving for PDR tells the auditor what level of DR is permitted to keep AAR at an acceptable level.

Revising Risks and Evidence

The audit risk model is primarily a planning model and is of limited use in evaluating results. If audit evidence suggests that the risk is higher than originally thought, the auditor must revise the original assessment and consider the effect of the revision on evidence requirements.

Factors Affecting Acceptable Audit Risk

The auditor's evaluation of management's integrity The degree to which external users rely on the statements based on these factors: Client size Distribution of ownership Nature and amount of liabilities The likelihood that a client will have financial difficulties after the audit based on these factors: Liquidity position Profits (losses) in previous years Method of financing growth Nature of the client's operations Competence of management

Materiality

The magnitude of an omission or misstatement of accounting information that makes it probable that the judgment of a reasonable person would have been changed.

Tolerable misstatement

The materiality allocated to any given account balance.

Preliminary judgment about materiality

The maximum amount by which the auditor believes that the statements could be misstated and still not affect the decisions of reasonable users.

Audit Risk for Segments

The risk of material misstatement, control risk, and inherent risk are assessed for each audit objective in each segment of the audit.

Business Risk

The risk that the auditor or audit firm will suffer harm because of a client relationship, even though the audit report rendered for the client was correct.

Audit assurance

This term is synonymous with acceptable audit risk

A significant risk

any risk that the auditor deems to require special attention.

The concepts of materiality and risk in auditing are

closely related and inseparable.

PDR

dependent on the other three factors in the model and will change only if the auditor changes one of the other factors.

Assessing inherent risk

is an attempt by the auditor to predict where misstatements are most and least likely in the financial statement segments. This affects the amount of audit evidence that the auditor needs to accumulate. This consideration takes place during the planning phase and is updated throughout the audit process.

Control risk

the risk that a material misstatement that could occur in an assertion will not be prevented or detected on a timely basis by the entity's internal controls.

engagement risk

the risk that the auditor (or firm) will suffer harm after the audit is finished, even though the report was correct.

Acceptable Audit Risk

the risk that the auditor may unknowingly fail to appropriately modify his or her opinion on financial statements that are materially misstated.

Engagement risk is closely related to client business risk because

the risk that the auditor will be sued is often related to business failure after the audit is finished.

Planned Detection Risk

the risk that the auditor will not detect a material misstatement that exists in an assertion.

Inherent risk

the susceptibility of an assertion to a material misstatement, assuming that there are no controls.