Chapter 7
Assessing specific
business risks and
materiality
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Assessing risk of material
misstatement
•
As discussed in chapter 5 and outlined in ASA/ISA
200:
– Risk of material misstatement may exist at both the
financial report level and at the assertion level
– Risk of material misstatement at the assertion level
consists of two components: inherent risk and
control risk.
• ASA 315/ISA 315 requires the auditor to identify and
assess risk of material misstatement at both the
financial report and assertion levels.
• Inherent risk is covered in chapter 7, control risk in
chapter 8.
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Learning objective 1:
Inherent risk
• Inherent risk (IR):
–
Susceptibility of account balance or class of transactions
to material misstatement given inherent and
environmental characteristics, but without regard to
internal control.
• An assessment of IR and control risk (CR)
can be combined or separate. Irrespective
of this, an auditor is required to:
–
–
Assess IR at financial report level for audit plan.
Assessment must then be related to assertions
at account balance or class of transactions level
when developing audit program.
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Business risk (BR) and IR
• An entity’s business strategy and associated risks
will affect an auditor’s assessment of IR at the
financial report level.
• Where possible, an auditor traces BRs to areas of
a financial report which are likely to be misstated.
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Factors affecting IR at financial
report level
• Integrity of management
• Management experience, knowledge
and changes during the period
• Unusual pressure on management
• Nature of entity’s business
• Factors affecting the industry.
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Inherent risk and information
technology (IT)
• As IT risks can be pervasive to the entity, factors
affecting overall IR associated with IT include:
– Significant changes in IT
– Insufficient IT skills and resources
– Lack of entity support and focus
– High dependence on IT
– Reliance on external IT
– Reliability and complexity of IT.
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Inherent risk at assertion level
• IR is greater for some assertions and related
classes of transactions, account balances and
disclosures than for others.
• Auditor will normally focus on:
–
–
–
–
–
–
Accounts likely to require adjustment
Complexity of underlying transactions
Judgement involved in determining account balances
Susceptibility of assets to loss or misappropriation
Occurrence of unusual and complex transactions,
particularly at or near year-end
Transactions not subject to ordinary processing.
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7-7
Effect of inherent risk on account
balance assertion
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7-8
Learning objective 2:
Special areas of audit risk
• ASA/ISA 315.27-.28 requires the auditor to determine
whether any of the risks identified are significant and
to specifically consider at least the following matters
when deciding which risks are significant:
–
–
–
–
–
–
Whether there is a risk of fraud
Whether the risk is related to recent significant developments
Complexity of the transactions
Whether the risk involves significant transactions with related
parties
The degree of subjectivity in the measurement of financial
information
Whether the risk involves significant unusual transactions.
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Special areas of audit risk: fraud
• Auditor’s responsibility for identifying and reporting
fraud introduced in chapter 4.
• At the planning stage, an auditor should
consider the risk that misstatements due to
fraud or error will not be detected.
• It is easier to miss material misstatements
resulting from fraud because fraud involves
acts designed to conceal it.
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Fraud
• Fraud is defined in ASA 240.11 (ISA 240.11) as:
–
‘An intentional act by one or more individuals among
management, those charged with governance,
employees, or third parties, involving the use of deception
to obtain an unjust or illegal advantage’.
• Therefore, there can be two types of misstatement
that are relevant to the auditor:
–
–
Misstatement resulting from fraudulent financial reporting
Misstatement resulting from misappropriation of assets.
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Fraudulent financial reporting
• Fraudulent financial reporting may involve:
–
Manipulation, falsification or alteration of records or
documents
–
Suppression or omission of the effects of transactions
from records or documents
–
Recording of transactions without substance; or
–
Intentional misapplication of accounting policies.
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Misappropriation of assets
• Misappropriation of assets may involve:
–
Embezzling receipts
–
Stealing assets
–
Causing an entity to pay for goods not received; or
–
Using an entity’s assets for personal use.
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Audit procedures for fraud at
planning stage
• In planning and conducting the audit the auditor must
exercise reasonable care and skill and maintain an
attitude of professional scepticism.
• An auditor will use his or her experience, knowledge
and training to determine whether fraud could occur.
• An auditor needs a thorough understanding
of a client’s business in order to identify opportunities
for the perpetration of fraud.
• ASA 240 (ISA 240) requires the auditor to specifically
consider the risks of material misstatement in the
financial report owing to fraud.
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Increased attention to fraud
• The most recently revised ASA 240/ISA 240
requires auditors to pay greater attention to fraud.
Auditors:
–
–
–
Need specifically to consider risks of material
misstatement in financial report due to fraud
Must discuss an entity’s susceptibility to fraud
with other members of the audit team
Must make more extensive inquiries of management
with respect to fraud.
• Auditors are now specifically required to consider
the risk of fraud in revenue recognition and the
possibility of management override of controls.
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Red flag indicators of fraud
• An auditor commonly uses a checklist to identify
increased risks of fraud. Where risk is high, it is
called a 'red flag'.
• These are listed in Table 7.1 (p. 317) and are
grouped under:
–
–
–
–
–
–
Management
Unusual pressures within an entity
Market pressures
Unusual transactions
Unsatisfactory records
IT environment.
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Fraud in practice
• A 2008 KPMG survey of fraud in Australia and New
Zealand identified the following main factors
allowing fraud to occur:
–
–
–
–
Poor internal controls
Override of controls
Collusion between employees and third parties
Collusion between employees and management.
• The survey found the majority of frauds, excluding
financial services entities, were perpetrated
internally. Gambling was a common motivator, and
15 per cent of largest frauds involved identity fraud.
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Earnings management
• Earnings management occurs when judgement in
financial reporting and in structuring transactions is
used to alter financial reports to influence the
perceptions of stakeholders.
• Earnings management involves those responsible
for preparing the financial report such as the Chief
Financial Officer (CFO) and Chief Executive Officer
(CEO).
• Incentives to manage earnings can be either
behavioural or market-based.
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Broad categories of earnings
management
• Earnings management by clients may fall into
the following categories:
–
–
–
–
Intentional violations of accounting standards,
and other reporting requirements that are individually
immaterial
Inappropriate revenue recognition
‘Big bath’ charges under the guise of restructuring
Improper accruals and estimation of liabilities
in good times.
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Illegal acts
• ASA/ISA 250 provides guidance on an auditor’s
consideration of illegal acts (noncompliance with
laws and regulations):
–
–
–
An auditor must understand the legal and regulatory
framework applicable to the entity and industry.
An audit normally does not include procedures
specifically designed to detect illegal acts.
An auditor must recognise circumstances requiring
special attention (e.g. a debenture deed requires
a specific current ratio be maintained) and consider
these in preparation of audit programs.
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Related parties
• ASA/ISA 550 requires auditors to specifically
assess the risk that related parties and relatedparty transactions will not be identified, or
appropriately disclosed and/or measured.
• An auditor must identify all related parties when
planning the audit because:
–
–
–
The existence of related parties or related-party
transactions can affect the financial information
The reliability of audit evidence is a function of the source
of that evidence
The initiation of a related-party transaction might be
motivated by other than ordinary business conditions,
such as fraud.
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Procedures for identifying
related parties
• Review the previous period’s working papers
for known related parties
• Make inquiries of management concerning
the names of all related parties
• Review the entity’s procedures for identifying
related parties
• Inquire about management’s and directors’
affiliations with other entities
• Review minutes of meetings
• Inquire of other auditors involved in the audit.
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Appropriateness of the going
concern basis
• Going concern assumption:
–
Entity is viewed as continuing in business for the foreseeable
future without any intention or necessity to liquidate or
otherwise cease its operations (ASA 570.2/ISA 570.2).
• ASA 570.10/ISA 570.10 requires auditors to assess
going concern at planning stage, as imminent
business failure might have an effect on
appropriateness of presentation of financial
report or might motivate management
misrepresentations.
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Appropriateness of the going
concern basis (cont.)
• Early identification helps focus audit effort on
appropriate assertions in the financial report, and
permits early communication with management.
• An auditor focuses primarily on anticipated events
during the relevant period, approximately 12 months
from the date of the current audit report to the
expected date of the next audit report.
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Examples of indications of going
concern problems
•
Financial indicators:
– High gearing, or fixed-term or reliance on short-term
borrowings
– Withdrawal of financial creditors, inability to pay
creditors or denial of trade credit by suppliers
– Negative operating cash flows or adverse key
financial ratios
– Lack of sustainable operating profits
– Dividend arrears
– Difficulty in complying with terms of loan agreements
– Inability to obtain necessary financing.
• See Table 7.2.
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Examples of indications of going
concern problems (cont.)
• Operating indicators include:
– Management intention to cease operations
– Loss of key management personnel
– Loss of major market, licence or franchise
– Prolonged industrial action
– Shortages of important supplies
– Emergence of highly successful competitors.
• See Table 7.2.
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Examples of indications of going
concern problems (cont.)
• Other indications:
– Non-compliance with capital or statutory requirements
– Legal proceedings against the entity
– Adverse changes in legislation or government policy
– Uninsured or underinsured disasters.
• See Table 7.2.
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Mitigating factors
• Auditor should consider mitigating factors.
These include:
Asset factors — sale of assets, or delayed
replacement
– Debt factors — unused lines of credit, ability
to renew or extend existing loans
– Cost factors — ability to reduce costs
– Equity factors — additional contributions
from owners, subsidiaries or associates.
–
• See Table 7.3.
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Learning objective 3:
Materiality
• Auditor must make preliminary assessment
of materiality when planning the audit.
• ‘Materiality’ defined: information, individually or in
aggregate, that if misstated or omitted from a
financial report may adversely affect decisions
about the allocation of scarce resources made by
financial report users (ASA/ISA 320.2).
• Auditor uses materiality to:
–
–
Evaluate the presentation of financial data
Determine the nature, timing and extent of audit
procedures (sometimes called planning materiality).
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Performance materiality
• ASA/ISA 320.11 requires the auditor to set
performance materiality for the purposes of
assessing future audit procedures.
• ASA/ISA 320.9 defines performance materiality as:
‘The amount or amounts set by the auditor at less
than materiality for the financial report as a whole
to reduce to an appropriately low level the
probability that the aggregate of uncorrected and
undetected misstatements exceeds materiality for
the financial report as a whole.’
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Materiality level
• As noted by ASA/ISA 320.6, the auditor will
consider the nature of the item when determining
the materiality level.
• Materiality is a concept of relative significance.
–
It depends on the amount of the item of interest and
some relevant basis of comparison.
• To estimate an amount for planning materiality, the
auditor selects a base and a suitable percentage to
apply to that base.
–
This requires professional judgment, and not all
auditors do it the same way.
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Choice of base
• The choice of a base depends on value judgements
about relevance, stability and predictability.
– Net profit may be the most relevant base for a
company with publicly traded securities. However,
because net profit can fluctuate significantly from
year to year it lacks stability, and it is not relevant
to entities such as non-profit organisations.
– Size-related bases such as total assets or total
revenue may be preferred because of their
relative stability.
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Rules of thumb for planning
materiality
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Financial information used as base
• Can be taken from:
–
Financial report to be audited (if available)
–
Annualised interim financial information; or
–
Previous period’s financial reports.
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Consideration of qualitative factors
in materiality
• An auditor should consider qualitative factors
as well as quantitative assessment. Qualitative factors
include:
–
The significance of the item to the particular entity
–
The pervasiveness of the misstatement (e.g. the
misstatement might affect the presentation of
numerous items in the financial report)
–
The effect of the misstatement on the financial report
as a whole.
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Materiality level for account
balances, classes of transactions or
disclosures
• An auditor needs to allocate planning materiality
to account balances and classes of transactions
for audit testing.
• ASA 320.10 (ISA 320.10) requires that the auditor
consider materiality at both the financial report level
and in relation to individual account balances,
classes of transactions and disclosures.
–
However it does not mandate the specific steps that an
auditor should take in allocating planning materiality.
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Relationship between materiality
and audit risk
• There is an inverse relationship between audit risk
and materiality.
• An auditor sets a lower materiality threshold for
accounts that have a higher audit risk. This means the
auditor will need to collect more evidence for these
riskier accounts.
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Accounting materiality
• Materiality is a matter of relative significance.
• Any quantitative guideline for determining materiality
must necessarily be arbitrary.
• However, AASB 1031 states that in the absence of
evidence or convincing argument to the contrary:
–
–
–
An amount that is equal to or greater than 10 per cent of an
appropriate base amount is presumed to be material.
An amount that is equal to or less than 5 per cent of an
appropriate base amount may be presumed not to be
material.
Determining whether an amount between 5 per cent and 10
per cent is material is a matter of judgement.
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Accounting materiality (cont.)
• In determining whether an amount or aggregate of an
item is material, the item should be compared with
one of the following base amounts:
–
–
–
•
Statement of financial position items—equity or the
appropriate asset or liability class total.
Income statement items—(1) profit or loss for the current
financial year; or (2) average profit or loss for a number of
years if net profit varies greatly from year to year.
Cash flow items—(1) net cash provided or used in the
operating, investing or financing activities as appropriate for
the current financial year; or (2) average net cash flows
provided by or used in the operating, investing or financing
activities, as appropriate for a number of years.
Evaluation of material misstatements identified during the
audit is covered in ASA/ISA 450, discussed in chapter 12.
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