Step 5: Evaluate Audit Evidence
Discrepancies in the accounting records.
Conflicting or missing evidential matter.
Problematic or unusual relationships between the auditor
and management.
Results from substantive of final review stage analytical
procedures.
Vague, implausible or inconsistent responses to inquiries.
Auditors should learn to mark the evidence, writing an identification
of the location, condition, date, time, and circumstances as soon as it
appears to be a signal of fraud. The marking should be on a
separate tag or page; the original document should be put in a
protective plastic envelope for preservation and locked away for
protection, and audit work should proceed with copies of documents
rather than originals.
McGraw-Hill/Irwin
©2007 by the McGraw-Hill Companies, Inc. All rights reserved.
Step 6: Communicate Fraud Matters
Minor frauds involving misappropriation of assets
by lower level employees should be reported to
management at least one level above those involved.
Frauds involving senior managers are never
inconsequential and should be reported along with
any frauds that result in material misstatement
directly to the audit committee.
McGraw-Hill/Irwin
©2007 by the McGraw-Hill Companies, Inc. All rights reserved.
Step 7: Document
Discussion of engagement personnel.
Procedures to identify and assess risk.
Specific risks identified and auditor response.
If revenue recognition not a risk—explain why.
Results of procedures regarding management override.
Other conditions causing auditors to believe additional
procedures are required.
Communication to management, audit committee, etc.
McGraw-Hill/Irwin
©2007 by the McGraw-Hill Companies, Inc. All rights reserved.
III. The Audit Risk Model
A. Audit Risk
B. The Components of Audit Risk
C. Risk Relationships
D. Inherent Risk
E. Other Factors Affecting Overall Inherent Risk
F. Control Risk
G. Detection Risk
H. Detection Risk and the Nature, Timing, and
Extent of Audit Procedures
McGraw-Hill/Irwin
©2007 by the McGraw-Hill Companies, Inc. All rights reserved.
A. AUDIT RISK
Audit Risk
Audit risk (AR) is the risk (likelihood) that the
auditor may unknowingly fail to modify the
opinion on financial statements that are materially
misstated (e.g., an unqualified opinion on
misstated financial statements.)
The AUDIT RISK MODEL decomposes overall
audit risk into three components: inherent risk
(IR), control risk (CR), and detection risk (DR):
AR = IR x CR x DR
McGraw-Hill/Irwin
©2007 by the McGraw-Hill Companies, Inc. All rights reserved.
B. The Components of Audit Risk
Internal Controls
Accounting
Information
System
Events,
Transactions
INHERENT RISK
The likelihood that,
in the absence of
internal controls,
an error or fraud
will enter the accounting
information system
CONTROL RISK
The likelihood that an error
or fraud will not get caught by the
client’s internal controls.
McGraw-Hill/Irwin
Substantive
Procedures
DETECTION RISK
The likelihood that
an error or fraud
will not be caught
by the auditor’s
procedures.
Financial
Statements
AUDIT RISK
The likelihood that
an error or fraud will occur,
and not get caught
by either the internal controls
or auditor’s procedures.
©2007 by the McGraw-Hill Companies, Inc. All rights reserved.
C. Risk Relationships
The auditor cannot affect inherent risk or control
risk. The auditor can only ASSESS them.
The auditor can only affect detection risk—
generally by examining more evidence.
Detection risk is inversely related to control risk
and inherent risk.
Detection risk is inversely related to competence
and reliability of evidence.
McGraw-Hill/Irwin
©2007 by the McGraw-Hill Companies, Inc. All rights reserved.
D. Inherent Risk
Inherent Risk (IR) is the likelihood that, in the absence of
internal controls, a material misstatement could occur. In
other words, it is a measure of the susceptibility of an
account to misstatement.
Factors affecting account inherent risk include:
Dollar size of the account
Liquidity
Volume of transactions
Complexity of the transactions
New accounting pronouncements
Subjective estimates
McGraw-Hill/Irwin
©2007 by the McGraw-Hill Companies, Inc. All rights reserved.
E. Other Factors Affecting Overall Inherent Risk
Competition
Economy
Nature of Industry
Management Style
Leverage
McGraw-Hill/Irwin
©2007 by the McGraw-Hill Companies, Inc. All rights reserved.
F. Control Risk
Control Risk (CR) is the likelihood that a
material misstatement would not be caught by the
client’s internal controls.
Factors affecting control risk include:
The environment in which the company
operates (its “control environment”).
The existence (or lack thereof) and
effectiveness of control procedures.
Monitoring activities (audit committee, internal
audit function, etc.).
McGraw-Hill/Irwin
©2007 by the McGraw-Hill Companies, Inc. All rights reserved.
G. Detection Risk
Detection risk (DR) is the risk that a
material misstatement would not be
caught by audit procedures.
Factors affecting detection risk include:
Sampling risk
Risk of choosing an unrepresentative sample.
Nonsampling risk
Risk that the auditor may reach inappropriate
conclusions based upon available evidence.
McGraw-Hill/Irwin
©2007 by the McGraw-Hill Companies, Inc. All rights reserved.
H. Detection Risk and the Nature, Timing,
and Extent of Audit Procedures
Lower Detection Risk
Higher Detection Risk
Nature
More effective tests.
Less effective tests.
Timing
Testing performed at
year-end.
Testing can be performed
at Interim.
Extent
More tests.
Fewer tests.
McGraw-Hill/Irwin
©2007 by the McGraw-Hill Companies, Inc. All rights reserved.
IV. Audit Programs and Procedures
A. Audit Programs
B. General Audit Procedures
C. Vouching/Tracing
D. Materiality
McGraw-Hill/Irwin
©2007 by the McGraw-Hill Companies, Inc. All rights reserved.
A. Audit Programs
List of audit procedures
to be performed.
Each audit program is
based, in part, on the
output of Audit Risk
Model.
Generally one for each
major cycle or account
Signed off as procedures
are performed.
McGraw-Hill/Irwin
©2007 by the McGraw-Hill Companies, Inc. All rights reserved.
B. General Audit Procedures
Inspection of records and documents
Vouching
Tracing
Scanning
Physical examination of tangible assets
Observation
Inquiry
Confirmation
Recalculation
Reperformance
Analytical Procedures
McGraw-Hill/Irwin
©2007 by the McGraw-Hill Companies, Inc. All rights reserved.
C. Vouching/Tracing
Q: Did all
recorded sales
actually occur?
Summary Listing
[Sales Journal]
Tracing
Vouching
(Completeness)
(Existence or Occurrence)
Source Documents
[Shipping documents]
McGraw-Hill/Irwin
Q: Were all sales
recorded?
©2007 by the McGraw-Hill Companies, Inc. All rights reserved.
D. Materiality
Materiality refers to an amount (or transaction) that would
influence the decisions of users (i.e., an amount (or event)
that would make a difference).
• Materiality Criteria:
Quantitative Criteria:
– Absolute size
– Relative size
– Cumulative effects
Qualitative Criteria
– Debt covenant
– Loss to profit
Ultimately, materiality is a matter of professional judgment.
McGraw-Hill/Irwin
©2007 by the McGraw-Hill Companies, Inc. All rights reserved.
Fraud can be hidden
from sight. Auditors
should be extremely
cautious in deciding
whether fraud is “clearly
inconsequential.”
McGraw-Hill/Irwin
©2007 by the McGraw-Hill Companies, Inc. All rights reserved.