Auditing
A Risk-Based Approach To Conducting A Quality Audit
10th edition
Karla M. Johnstone | Audrey A. Gramling | Larry E. Rittenberg
CHAPTER 7
PLANNING THE AUDIT: IDENTIFYING AND RESPONDING
TO THE RISKS OF MATERIAL MISSTATEMENT
LEARNING OBJECTIVES
1.
2.
3.
4.
5.
Describe the concept of material misstatement and
apply a process for making materiality assessments
Identify the risks of material misstatement and
describe how they relate to audit risk and detection
risk
Assess factors affecting inherent risk, including
fraud risk factors
Assess factors affecting control risk
Use planning analytical procedures to identify areas
of heightened risk of material misstatement
7-2
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LEARNING OBJECTIVES
7.
8.
Describe how auditors make decisions about
detection risk and audit risk
Respond to the assessed risks of material
misstatement and plan the procedures to be
performed on an audit engagement
7-3
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THE AUDIT OPINION FORMULATION
PROCESS
7-4
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LEARNING OBJECTIVE 1
DESCRIBE THE CONCEPT OF MATERIAL MISSTATEMENT
AND APPLY A PROCESS FOR MAKING MATERIALITY
ASSESSMENTS
WHAT IS A MISSTATEMENT
• 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
• Auditors are concerned about material
misstatements
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MATERIALITY JUDGMENTS
• (1) are a matter of professional judgment
• (2) depend on the needs of a reasonable
person relying on the information (an investor,
potential investor, or other stakeholder)
• (3) involve both quantitative and qualitative
considerations
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DEFINING MATERIALITY
Materiality
• Magnitude of an omission or misstatement of
accounting information that, in view of
surrounding circumstances, makes it
probable that the judgment of a reasonable
person relying on the information would
have been changed or influenced by the
omission or misstatement
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DEFINING MATERIALITY
According to ISA
320, Materiality in
Planning and
Performing an Audit
According to the
Supreme Court of
the United States
Auditors’ judgments
about materiality should
be made based on a
consideration of
information needs of
users as an overall group
Fact should be viewed
by reasonable investors
as having significantly
altered total mix of
information made
available
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A PROCESS FOR MAKING MATERIALITY
ASSESSMENTS
• Consider a client where financial statement
materiality is set at $150,000 and materiality for the
accounts receivable balance is set at $110,000.
• The performance materiality for auditing accounts
receivable might then be set at $30,000.
• This approach compensates for the possibility that
multiple undetected or uncorrected misstatements
in the accounts receivable balance might exist.
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PROCESS FOR MAKING MATERIALITY
ASSESSMENTS
• The auditor will aggregate identified misstatements
so the audit team can assess the materiality of these
misstatements
• The document where misstatements are aggregated
is often referred to as a summary of unadjusted
audit differences (SUAD)
• Clearly trivial amount (posting materiality)
• Inconsequential, whether:
• Taken individually or in the aggregate
• Judged by any criteria of size, nature, or circumstances
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QUALITATIVE CONSIDERATIONS
• Auditors consider both quantitative effects (such as the
dollar magnitude of a misstatement) and qualitative effects (such
as the reason for the misstatement)
• Qualitative reasons for considering quantitatively
small misstatement material
• Hiding failure to meet analysts’ consensus
expectations
• Changing a loss into income, or vice versa
• Affecting compliance with loan covenants
• Effecting the increases in management’s
compensation
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7-12
LEARNING OBJECTIVE 2
IDENTIFY THE RISKS OF MATERIAL
MISSTATEMENT AND DESCRIBE HOW THEY
RELATE TO AUDIT RISK AND DETECTION RISK
RISK DEFINITIONS
Inherent Risk
• The susceptibility of an assertion about a class of transaction,
account balance, or disclosure to a misstatement that could
be material, either individually or when aggregated with
other misstatements, before consideration of any related
controls.
Control Risk
• The risk that a misstatement that could occur in an assertion
about a class of transaction, account balance, or disclosure
and that could be material, either individually or when
aggregated with other misstatements, will not be prevented,
or detected and corrected, on a timely basis by the entity’s
internal control.
7-14
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RISK DEFINITIONS
Audit Risk
• The risk that the auditor expresses an inappropriate
audit opinion when the financial statements are
materially misstated.
Detection Risk
• The risk that the procedures performed by the
auditor to reduce audit risk to an acceptably low
level will not detect a misstatement that exists and
that could be material, either individually or when
aggregated with other misstatements.
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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
7-16
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LEARNING OBJECTIVE 3
ASSESS FACTORS AFFECTING INHERENT RISK,
INCLUDING FRAUD RISK FACTORS
INHERENT RISK AT THE ACCOUNT / ASSERTION
LEVEL
• Factors indicating a higher level of inherent risk
• 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
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INHERENT RISK AT THE FINANCIAL
STATEMENT LEVEL: BUSINESS RISKS
• Inherent risk at financial statement level that affects
business operations and potential outcomes of
organizational activities
• Examples of factors affecting this risk
•
•
•
•
Overall economic climate
Technological changes
Competitor actions
Geographic locations of suppliers
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RISK ASSESSMENT PROCEDURES 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
7-20
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INHERENT RISK AT THE 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
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RISK ASSESSMENT PROCEDURES FOR
ASSESSING MANAGEMENT INTEGRITY
• Inquiries
•
•
•
•
•
•
Predecessor auditor
Other professionals in business community
Other auditors within audit firm
Management
Audit committee members
Federal regulatory agencies
• Review
• News media and Web searches
• Public databases
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7-22
FACTORS INDICATING A HIGHER LEVEL OF
INHERENT RISK – FINANCIAL REPORTING RISKS
• 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
7-23
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RISK ASSESSMENT PROCEDURES FOR
ASSESSING FRAUD RISK
• Brainstorming
• A group discussion designed to encourage auditors to
creatively assess client risks, particularly those relevant
to possible existence of fraud
• Occurs during the early planning phases of audit
• Attended by entire engagement team and led by audit
partner or manager
• Other Procedures
• Inquiry
7-24
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LEARNING OBJECTIVE 4
ASSESS FACTORS AFFECTING CONTROL RISK
CONTROL RISK
• Relates to susceptibility that a misstatement will not
be prevented or detected on a timely basis by
internal control system
• The assessment can be made at:
• Overall financial statement level
• Account or assertion level
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FACTORS LEADING TO A HIGHER
ASSESSMENT OF CONTROL RISK
Poor controls in specific countries or locations
Difficulty gaining access to the organization or those in control
Little interaction between senior management and operating staff
Weak tone at the top and poor control environment
Inadequate accounting staff and information systems
Growth of organization exceeds accounting system Disregard of regulations for prevention of
illegal acts
No internal audit function
7-27
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RISK ASSESSMENT PROCEDURES FOR
ASSESSING CONTROL RISK
• Interview relevant parties to 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
7-28
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LEARNING OBJECTIVE 5
USE PLANNING ANALYTICAL PROCEDURES TO IDENTIFY
AREAS OF HEIGHTENED RISK OF MATERIAL
MISSTATEMENT
PLANNING ANALYTICAL PROCEDURES
Used as a
risk
assessment
procedure
can help
auditors
•Improve their understanding
of the client’s business.
•Identify risks of material
misstatement in particular
account balances and
direct the auditor’s attention
to high-risk areas
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AN EXAMPLE OF A PLANNING
ANALYTICAL PROCEDURE
• The auditor may develop an expectation of revenue
based on production capacity.
• Recorded revenue in excess of this expectation may
indicate a heightened risk of misstatement in the
revenue account—due to either fraud or error.
• The auditor will then want to plan audit procedures
to obtain sufficient appropriate evidence for the
revenue account
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TYPES OF ANALYTICAL PROCEDURES
• Trend analysis: Based on the history of changes in
the account or ratio
• Ratio analysis: Identifies relevant ratios to determine
whether there are significant differences between
the client results and auditor expectations
See Exhibit 7.3 for Commonly Used Ratios
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LEARNING OBJECTIVE 6
DESCRIBE HOW AUDITORS MAKE DECISIONS
ABOUT DETECTION RISK AND AUDIT RISK
DETERMINING AUDIT RISK AND
DETECTION 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
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QUANTITATIVE EXAMPLE: 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 model
Audit Risk = Inherent Risk × Control Risk × Detection Risk
0.01 = 1.00 × 1.00 × Detection Risk
Detection Risk = 0.01 / (1.0 × 1.0) = 1%
7-35
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QUANTITATIVE EXAMPLE: 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 Risk
0.05 = 0.50 × 0.20 × Detection Risk
Detection Risk = 0.05 / (0.50 × 0.20) = 50%
7-36
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LEARNING OBJECTIVE 7
RESPOND TO THE ASSESSED RISKS OF MATERIAL
MISSTATEMENT AND PLAN THE PROCEDURES TO
BE PERFORMED ON AN AUDIT ENGAGEMENT
PLANNING AUDIT PROCEDURES TO RESPOND TO
THE ASSESSED RISKS OF MATERIAL MISSTATEMENT
• Auditor should determine whether the audit will be:
• Controls reliance audit
• Substantive audit
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PLANNING AUDIT PROCEDURES TO RESPOND TO
THE ASSESSED RISKS OF MATERIAL MISSTATEMENT
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
• Consider the role of internal controls,
and determine whether control risk is
relatively high or low
• Obtain more relevant and reliable
evidence with increases in assessment of
risk of material misstatement
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RISK RESPONSES
Nature of
response
• Type of audit procedure
Timing of
response
• When procedure is
performed
Extent of
response
• Amount of evidence
7-40
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