Li Yuen Yung
Wong Wai Kit
Wong Yik Yin
ACCT 351
CLASS PRESENTATION
Agenda
 Audit Risk Model
 Reasons for high audit risk in China
 Inherent Risk (IR)
 Control Risk (CR)
 Detection Risk (DR)
 Conclusion
 Recommendation
AUDIT RISK MODEL
Audit Risk Model
IR
CR
DR
Audit Risk Model
 Inherent Risk (IR)
 Risk of material misstatement assuming the
company has no internal controls
 Control Risk (CR)
 Risk that a material misstatement is not detected
by internal controls
 Detection Risk (DR)
 Risk that an auditor would not detect material
misstatement using analytical procedures or
substantive tests
Risk of material misstatement assuming the company has no internal
controls
INHERENT RISK
Reasons for high inherent risk
 Management integrity
 Company characteristics
 Companies’ choice on auditors
 Legal environment and corporate governance
Management Integrity
 62% CFOs cited ‘integrity’ as the top criteria
in choosing accounting firms
 38% cited integrity not in top 3
 3% choose auditors who submit to client’s
opinion
Company Characteristics
 Many State-owned Enterprises (SOE)
 In 2003, 76% of listed com are SOEs
 Weaker incentives to reduce information
asymmetries
 Banks discrimination
 Insurance function of Chinese government
Companies’ Choice on auditors
 Choose small and local audit firms
 Small and local firms dominates market
 54% in 2003
 Small and local firms
 Less independent
 Easier to collude with
 Why?
Choice on auditors
 Small firms
 More dependent on audit fee on single com
 Smaller potential loss from being caught
 Local firms
 Close relationships with local com
Legal environment
 Weak legal culture and enforcement system
 PRC GAAP, but not follow
 Information disclosure are not timely and
accurate, and not easily understandable by
investors.
 Prevalent of false accounts
Risk that a material misstatement is not detected by internal control
CONTROL RISK
Reasons for high control risk
 Insider Control of Corporate Affairs
 Weak Supervisory Board
Reasons for high control risk
 Insider Control of Corporate Affairs
 Control is mainly by insider-managers
 insider-managers controlled and supported in various
forms by Communist Party
the shareholders
not act in the interest of
 Communist Party can exert a critical influence on company
affairs.
 Eg. the use of listed companies as guarantors to borrow
money from banks
 As a result, internal control become useless
Reasons for high control risk
 Weak Supervisory Board in listed company
 A group of individuals chosen by the stockholders to hire and
supervise the executive directors, managers and CEO
 required by the Company Law in China
 however, loosely defined monitoring role over the board of
directors and managers
 Supervisors are not involved in the selection of directors and
managers and have no means of disciplining them
 ineffective governance and supervising role
Risk that an auditor would not detect material misstatement using
analytical procedures or substantive tests
DETECTION RISK (DR)
Reasons for high detection risk
 Few and weak regulatory bodies
 Generally poor quality of auditors
 Low penalty
 Compensation from higher fee for both audit and non-
audit services
Reasons for high detection risk
 Few and weak regulatory bodies
 2-digits GDP growth in the past few years
 Increasing number of companies listed
 Increasing number of financial statement stated
 Although local accounting firms started to merge
 Still large amount of small and medium size firms which
are difficult to monitor
 Only 2 government agencies in China
 China Securities Regulatory Commission
 Ministry of Finance
Reasons for high detection risk
 Generally poor quality of auditors
 Perception of junior auditors
 No experience, but work hard
 No understanding of client’s industry and background
 Non-sampling errors from audit in China is more
common
 Not able to construct effective procedures and apply
procedures effectively
 Due to time constraints and demanding deadline, more
susceptible to material misstatement
Reasons for high detection risk
 Low penalty
 Protection to bigger firms
 Scandals of China Life with KPMG
 Cost of take risky project is low
 Compared to penalty from other countries
Reasons for high detection risk
 Compensation from higher fee for both audit
and non-audit services
 Even accounting firms think that a prospective clients
is not decent and have poor reputation
 Higher fee from both audit and non-audit service will
compensate the increased audit risk
 Cost-Benefit analysis
 Accept the engagement if benefits is greater the cost of
taking the risk
 Illustrated by following example
Detection risk
 Example:
 Audit fee: $1mil
 Probability of false account: 50%
 Probability of false account being caught: 10%
 Fine if get caught: $10mil
Detection risk
 Expected value of project
= 1mil – 10mil *0.5*0.1
= 0.5mil
 As the expected value is positive, accounting
firms in China will still take project even the
audit risk is high
Conclusion
China
Client’s
poor
integrity
Ineffective
Corporate
governance
Low ethical
standards
of auditors
High Audit Risk in China
Recommendations
 Improving internal control
 Implementing CEO Certification - requires that the
CEO to prepare a statement to accompany the
audit report to certify the appropriateness and
fairness of the financial statements.
 Adopt Corporate Governance Guidelines, and
Code of Business Conduct and Ethics – raise the
ethical standards of the management
Recommendations
 Improving audit quality and independence
 Strengthening Legal Liabilities and Enforcement –
increase penalty
 raise the ethical standard of auditor – education
and training
 create strong and independent regulatory
bodies – more resources and power should be
allocated