Learning Objectives Learning Objectives Child Development Stages
Learning Objectives
description
Transcript of Learning Objectives
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
Copyright © 2014 South-Western/Cengage Learning
Chapter 7Planning the Audit: Identifying and Responding
to the Risks of Material Misstatement
Copyright © 2014 South-Western/Cengage Learning7-2
Learning Objectives
1. Define the concept of material misstatement and discuss the importance of materiality judgments in the audit context
2. Identify the risks of material misstatement and describe how they relate to audit risk and detection risk
3. Assess factors affecting inherent risk4. Assess factors affecting control risk
Copyright © 2014 South-Western/Cengage Learning7-3
Learning Objectives
5. Use preliminary analytical procedures and brainstorming to identify areas of heightened risk of material misstatement
6. Describe how auditors make decisions about detection risk and audit risk
Copyright © 2014 South-Western/Cengage Learning7-4
Learning Objectives
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
Copyright © 2014 South-Western/Cengage Learning7-5
THE AUDIT OPINION FORMULATION PROCESS
Copyright © 2014 South-Western/Cengage Learning7-6
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
Copyright © 2014 South-Western/Cengage Learning7-7
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
the audit context
Learning Objective 1
Copyright © 2014 South-Western/Cengage Learning7-9
Assessing Materiality
• 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
designing and conducting a quality audit
Copyright © 2014 South-Western/Cengage Learning7-10
Assessing Materiality
Copyright © 2014 South-Western/Cengage Learning7-11
Assessing Materiality
• According to ISA 320, Materiality in Planning and Performing an Audit• Auditors’ judgments
about materiality should be made based on a consideration of information needs of users as an overall group
• According to the Supreme Court of the United States• Fact should be viewed by
reasonable investors as having significantly altered total mix of information made available
Copyright © 2014 South-Western/Cengage Learning7-12
Materiality Guidance
• Audit firms provide auditors with:• Specific written guidance• Decision aids
• Levels considered by auditors• Materiality for the financial statements as a whole• Performance materiality for particular classes of
transactions, account balances, or disclosures
Copyright © 2014 South-Western/Cengage Learning7-13
Materiality Guidance
• 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
procedures
Copyright © 2014 South-Western/Cengage Learning7-14
Materiality Guidance
• 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
Copyright © 2014 South-Western/Cengage Learning7-15
SEC Views on Materiality
• Criticisms of the auditing profession• Netting material misstatements• Not applying materiality concept to swings in
accounting estimates• Consistently passing on individual adjustments that
may not be considered material
Copyright © 2014 South-Western/Cengage Learning7-16
SEC Views on Materiality
• 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
Copyright © 2014 South-Western/Cengage Learning7-17
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
making of materiality judgments have changed
Copyright © 2014 South-Western/Cengage Learning7-18
Changes in Materiality Judgments
• Auditors make professional judgments about size of material misstatements providing a basis for:• Determining nature and extent of risk assessment
procedures• Identifying and assessing risks of material
misstatement• Determining nature, timing, and extent of tests of
controls and substantive audit procedures
Identify the risks of material misstatement and describe how they relate to audit risk and
detection risk
Learning Objective 2
Copyright © 2014 South-Western/Cengage Learning7-20
EXHIBIT 7.1 - Risks Relevant to an Audit
Copyright © 2014 South-Western/Cengage Learning7-21
risk of material misstatement
• Exists at the financial statement level and assertion level• Categories of risk within these levels• Inherent risk • Control risk
• Risk of material misstatement high - Auditor accepts less audit risk • Risk of material misstatement lower - Auditor
accepts more audit risk
Copyright © 2014 South-Western/Cengage Learning7-22
risk of material misstatement
• Detection risk: Level of audit effort that auditor will expend on engagement depends on level of detection risk
When risk of material
misstatement is higher
Detection risk is set lower
Increase in evidence obtained
through substantive audit
procedures
Copyright © 2014 South-Western/Cengage Learning7-23
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
normal course of business
Assess factors affecting inherent risk
Learning Objective 3
Copyright © 2014 South-Western/Cengage Learning7-25
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
nonroutine transactions
Copyright © 2014 South-Western/Cengage Learning7-26
Business Risks
• 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
Copyright © 2014 South-Western/Cengage Learning7-27
factors For assessment of inherent risk of operations at higher level
• Lack of expertise to deal with changes in industry• Uncertain likelihood of successful introduction of
new product and acceptance by market• Information technology being incompatible across
systems • Expansion of business for which demand not
accurately estimated• Implementation of incomplete business strategy• New regulatory requirements increase legal exposure
Copyright © 2014 South-Western/Cengage Learning7-28
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
Copyright © 2014 South-Western/Cengage Learning7-29
Sources of Information for Assessing Business Risks
• Management inquiries• Review of client’s budget• Tour of client’s plant and
operations• Review government
regulations and client’s legal obligations• Knowledge management
systems
• Online searches• Review of SEC filings• Company Web sites• Economic statistics• Professional practice
bulletins• Stock analysts’ reports• Company earnings calls
Copyright © 2014 South-Western/Cengage Learning7-30
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
Copyright © 2014 South-Western/Cengage Learning7-31
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
Copyright © 2014 South-Western/Cengage Learning7-32
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
Copyright © 2014 South-Western/Cengage Learning7-33
factors for assessment of inherent risk of financial reporting at higher level
• Discrepancies in accounting records• Unusual relationships
between auditor and management• Lack of management
competence• Company history of meeting
analyst estimates or high earnings growth expectations
• An impending initial public offering of stock• Disagreements over
financial reporting with prior auditors• Auditor resignation• Unusual transactions with
outsiders or significant related party transactions
Copyright © 2014 South-Western/Cengage Learning7-34
factors for assessment of inherent risk of financial reporting at higher level
• Transactions for which most of the revenue or expense is recognized at inception of transaction• Financial results that
seem too good to be true• Complex business
arrangements that serve little practical purpose
• Evasiveness from management regarding questions about financial statements• Insistence by CEO or CFO
to be present at all meetings • Accounting methods
appearing to favor form over substance
Copyright © 2014 South-Western/Cengage Learning7-35
Auditing in Practice - Application of Accounting Principles and Related Disclosures
• Auditor needs to: • Determine whether management’s decisions are
appropriate and consistent with financial reporting framework • Develop expectations about appropriate disclosures
that are necessary• Compare those expectations to disclosures made by
management in assessing inherent risks
Assess factors affecting control risk
Learning Objective 4
Copyright © 2014 South-Western/Cengage Learning7-37
Control Risk
• 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
Copyright © 2014 South-Western/Cengage Learning7-38
Assessing Factors Affecting Control Risk
• Poor controls in specific countries or locations• Difficulty gaining access to the organization or
determining the controllers of the organization• Little interaction between senior management and
operating staff• Weak tone at the top leading to a poor control
environment• Inadequate accounting staff and information systems
Copyright © 2014 South-Western/Cengage Learning7-39
Assessing Factors Affecting Control Risk
• 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
Copyright © 2014 South-Western/Cengage Learning7-40
Auditing in Practice - Lack of Oversight as a Control Weakness Leads to Embezzlement
• Rita Crundwell and the City of Dixon, Illinois• $50+ million fraud• Auditors need to be aware of weak internal controls
and negative consequences for a client’s financial statements• Control risk assessment as high means a need to
perform additional substantive procedures• Assessment of control risk as low means a need to test
those controls for operational efficiency
Copyright © 2014 South-Western/Cengage Learning7-41
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
Copyright © 2014 South-Western/Cengage Learning7-42
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
material misstatement
Learning Objective 5
Copyright © 2014 South-Western/Cengage Learning7-44
Preliminary Analytical Procedures
Developing an expectation
Determining when the difference between auditor’s expectation and client’s records would be significant
Computing that difference
Following up on significant differences
Copyright © 2014 South-Western/Cengage Learning7-45
Types of Analytical Techniques
• 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
Copyright © 2014 South-Western/Cengage Learning7-46
Types of Analytical Techniques
• 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
in ratio changes between years
Copyright © 2014 South-Western/Cengage Learning7-47
EXHIBIT 7.3 - Commonly Used Ratios
Copyright © 2014 South-Western/Cengage Learning7-48
Ratio and trend analysis
• 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
account balances, or other bases of expectations
Copyright © 2014 South-Western/Cengage Learning7-49
Brainstorming
• 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
audit partner or manager
Copyright © 2014 South-Western/Cengage Learning7-50
guidelines followed during brainstorming session
Copyright © 2014 South-Western/Cengage Learning7-51
Steps in Brainstorming sessions
Reviewing prior year client information
Considering client information, particularly with respect to the fraud triangle
Integrating information from previous steps into an assessment of likelihood of fraud in engagement
Identifying audit responses to fraud risks
Describe how auditors make decisions about detection risk and audit risk
Learning Objective 6
Copyright © 2014 South-Western/Cengage Learning7-53
Determining Detection Risk and Audit Risk
• Auditor determines level of detection risk on the basis of: • Assessment of risk of material misstatement at all
levels• Consideration of desired level of audit risk
• Determining detection risk influences nature, amount, and timing of substantive audit procedures
Copyright © 2014 South-Western/Cengage Learning7-54
Detection Risk and Audit Risk
• Detection risk is affected by:• Effectiveness of substantive auditing procedures
performed• Extent to which the procedures were performed with
due professional care• High level of detection risk• Audit firm is willing to take higher risk of not detecting
a material misstatement• Audit risk is also high
Copyright © 2014 South-Western/Cengage Learning7-55
Detection Risk and Audit Risk
• Low level of detection risk• Audit firm is not willing to take as much of a risk of not
detecting material misstatement• Audit risk is also low
• Audit risk usually set at between 1% and 5% • Detection risk ranges from 1% to 100%
Copyright © 2014 South-Western/Cengage Learning7-56
EXHIBIT 7.4 - Risks and Their Effects on Audit Work
Copyright © 2014 South-Western/Cengage Learning7-57
EXHIBIT 7.4 - Risks and Their Effects on Audit Work
Copyright © 2014 South-Western/Cengage Learning7-58
High Risk of Material Misstatement
• Assuming an account with many complex transactions and weak internal controls• Inherent risk and control risk assessed at their
maximum • Audit risk set at a low level
• Audit risk modelAudit Risk = Inherent Risk × Control Risk × Detection Risk
0.01 = 1.00 × 1.00 × Detection RiskDetection Risk = 0.01 / (1.0 × 1.0) = 1%
Copyright © 2014 South-Western/Cengage Learning7-59
Low Risk of Material Misstatement
• 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%
respectively• Audit risk set at 5%
Audit Risk = Inherent Risk × Control Risk × Detection Risk0.05 = 0.50 × 0.20 × Detection Risk
Detection Risk = 0.05 / (0.50 × 0.20) = 50%
Copyright © 2014 South-Western/Cengage Learning7-60
Auditing in Practice - An Expanded Version of Audit Risk Model
Respond to the assessed risks of material misstatement and plan the procedures to be
performed on an audit engagement
Learning Objective 7
Copyright © 2014 South-Western/Cengage Learning7-62
Planning Audit Procedures to Respond to the Assessed Risks of Material Misstatement
• Auditor should design: • Controls reliance audit • Substantive audit
• When considering risk responses, auditor should:• Evaluate reasons for assessed risk of material
misstatement• Estimate likelihood of material misstatement due to
inherent risks of client
Copyright © 2014 South-Western/Cengage Learning7-63
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
Copyright © 2014 South-Western/Cengage Learning7-64
EXHIBIT 7.5 - Effect of Risk Assessment on Risk Response
Copyright © 2014 South-Western/Cengage Learning7-65
Nature of Risk Response
• 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
Copyright © 2014 South-Western/Cengage Learning7-66
Timing of Risk Response
• 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
Copyright © 2014 South-Western/Cengage Learning7-67
Timing of Risk Response
• 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
Copyright © 2014 South-Western/Cengage Learning7-68
Timing of Risk Response
• Procedures that can be completed only at or after period end• Comparison of financial statements to accounting
records• Evaluation of adjusting journal entries made by
management in preparing financial statements• Conduct procedures to respond to risks that
management may have engaged in improper transactions at period end
Copyright © 2014 South-Western/Cengage Learning7-69
extent of risk response
• 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
Copyright © 2014 South-Western/Cengage Learning7-70
Auditing in Practice - The City of Dixon, Illinois Sues Its Auditor Related to Rita Crundwell Embezzlement
• The lawsuit alleges: • Professional negligence • Negligent misrepresentation• Certain deficiencies in audit procedure
• Severe consequences to all parties involved • When auditors fail to assess and appropriately respond
to risk of material misstatement