Audit Risk and Materiality

• Audit risk and materiality are significant in evidence gathering, determining the amount of evidence to gather

Risk Types

• Engagement risk: loss/injury to professional practice from litigation/adverse publicity, not part of the Audit Risk Model (ARM)
• Business risk: conditions/events impacting meeting objectives/executing strategies, can form material misstatements
• Audit Risk: auditors not modifying the Financial Statement (F/S) audit opinion, and F/S are materially misstated
• Allowable Audit Risk: Auditor willingness to accept financial statements as materially misstated after a clean audit opinion (0.01-0.05)
• Inherent risk (IR): material misstatement exists without considering client's internal controls, not controlled by them
• Susceptibility of an assertion to material misstatement, assuming no related controls
• Material misstatement risk includes inherent risk.
• Evaluating obsolete inventory requires judgment
• Control risk (CR): Client internal controls cannot prevent/detect misstatement, considering internal controls
• Supervisors reviewing monthly bank reconciliations ensure timely preparation
• Detection risk (DR): auditor failing to detect material misstatement via sampling or non-sampling risk
• DR has an inverse relationship to Inherent Risk (IR) and Control Risk (CR)
• The higher Risk of Material Misstatement (RMM), the lower Detection Risk (testing increases)
• Direct relationship to Audit Risk (AR)
• The lower planned Audit Risk (AR), the lower Detection Risk (testing increases)
• Example: Very low Audit Risk (AR), high Inherent Risk (IR), very high Control Risk (CR) = very low Detection Risk (DR)

Sampling vs Non-Sampling Risk

• Nonsampling risk: risk of human error/audit failure
• Sampling risk: sample not representing the population
• Detection risk arises from non-sampling through mistakes in design, evidence, or conclusions.
• Detection risk arises from sampling when material misstatement is not detected.

Audit Risk Model (AR = RMM X DR)

• Risks are set by the auditor like AR is controllable, those assessed by the auditor are out of their control
• ARM includes inherent, control, detection, and audit risk
• Assessment
• Set Audit Risk (AR) level
• Assess RMM = IR + CR
• Solve the Audit Risk Model equation for Detection Risk allowable
• Auditors control audit risk (AR) and DR, but cannot control RMM (IR x CR)
• Determine the amount of substantive testing with Detection Risk (DR) level

Determining Detection Risk

• DR = AR / (IR x CR)
• DR low = AR very low-low / (IR high-very high) x (CR high)
• Purpose for solving DR when applying the audit risk model is to determine the amount of substantive testing

Relationships between Risk components and Testing

• Allowable DR has an inverse relation to RMM, RMM includes Inherent Risk (IR), and Control Risk (CR)
• Direct relation to AR
• As planned AR increases, testing increases (lower DR)
• Allowable DR has an inverse relation to substantive testing
• As allowable DR decreases, testing increases
• RMM has a direct relation to testing
• As Inherent Risk (IR) and Control Risk (CR) increases, testing increases
• Tolerable Misstatement (TM) has a direct relation to DR
• As Tolerable Misstatement (TM) decreases, allowable DR decreases
• Tolerable Misstatement (TM) has an inverse relation to testing
• As Tolerable Misstatement (TM) decreases, testing increases
• At very low audit risk, substantive testing is very high

Picture Example

• AR -> LOW, DR -> LOW, Testing -> HIGH

Auditor's Risk Assessment

• Auditors should understand the company, its environment, and factors impacting risks of material misstatement
• Relevant industry and nature of the company
• Company accounting principles and measurement of performance
• Company objectives/strategies and related business risks

Factors Driving Inherent Risk

• Complexity of accounts
• Degree of judgement
• Fraud risks
• Changes in industry/environment/business
• Business risks

Business Risk

• Risks from significant events adversely affecting a company's ability to achieve objectives/execute strategies
• Affects Inherent Risk (IR) since these risks can result in material misstatement of Financial Statements (F/S) at the assertion or account level
• Factors influencing Inherent risk (IR) must link to account/assertion level
• Identified risks can lead to increased inherent risk

Audit Risk Model Limitations

• Desired audit risk level may not be achievable
• Model does not account for auditor judgment error, preliminary risk level
• As the planned Audit Risk (AR) decreases, the amount of testing increases, and allowable Detection Risk (DR) decreases

Misstatements

• Errors are unintentional
• Intentional, fraudulent misstatements include fraudulent reporting and misappropriation of assets

Causes of Misstatements

• Inaccurate data gathering/processing
• Omission of items/disclosures
• Inaccurate application/omission of GAAP
• Accounting estimate errors/aggressiveness in management's judgments

Fraudulent vs Misappropriation

• Fraudulent aims to deceive users implemented through fake revenue
• Misappropriation is theft/misuse through stealing inventory

Fraud Triangle

• Incentive/pressure
• Opportunity
• Rationalization/attitude
• Fraud risk using this framework
• All three conditions must exist for fraud risk to be increased
• Incentive impacts Inherent Risk (IR) creating fraud based on company environment/situation
• Opportunity impacts Control Risk (CR) and weak controls create chance
• Rationalization impacts both Inherent Risk (IR) & Control Risk (CR) supporting intention, leading to undetected fraud

Auditor's Fraud Responsibility

• Auditors must provide reasonable assurance of material misstatement free financial statements via:
• Exercising care and skepticism
• Planning/performing audits for reasonable assurances
• Communicating findings to the management committee
• Absolute assurance is unattainable due to limitations, fraud characteristics, etc.

Auditor's Fraud Findings

• If fraud is identified, auditors communicate to:
• Management and audit committees
• 3rd party if required for legal or regulatory reasons, auditor succession, subpoena, or governmental assistance

Analytical Procedures

• Done to obtain, clean, transform, and to identify and communicate patterns, trends, outliers, and information to use in decision making
• Including analysis of operational, financial, and other data
• Data mining provides actionable results, repeated to search for patterns to identify anomalies

Data Analytical Types

• Predictive: Future outcomes or trends identified include analysis of cash receipts indicate previous payment history
• Prescriptive: Evaluate the course of action would lead to the best potential outcome/predictions
• Descriptive: Past event reports characterize, including account analysis
• Diagnostic: Cut of data in different ways to understand additional insight

Data Analytics in Audits

• Is essentially a form of data analytics by external auditors
• Helps auditors identify possible risk areas in the planning stage

Big Data

• Data that’s too large or complex to process using traditional methods
• 3 V's are volume, velocity, and variety

Audit Data Analytics (ADA)

• Science and art using analysis, modeling, and visualization
• Helps discover and analyze patterns, anomalies for planning/performing an audit

ADA Techniques

• Ratio: comparisons over time with bar graphs
• Sorting: nonfinancial categories with bar graph
• Trend: software trends of time with a sparkline
• Matching: matching various source; dots
• Comparisons: year over year with balances
• Forecasting: extrapolate with past patterns

Analytical Procedure Phases

• Understanding the business
• Evaluating internal controls
• Indicates possible misstatements
• Substantive analytical procedures

Interpret key Patterns Analytical procedures

• Ratio, volume, trend analysis, etc
• Financial statement fluctuations, not typical relations

Use in Risk Assessment

• In planning stage of the audit using preliminary analytical procedures required by auditing standards

Substantive Analytical Procedures

• Use more disaggregated data though isn't required by auditing standards
• Final Analytical: identify tests and procedures (required)

Interpret key financial ratios

• Liquidity measures the ability to pay short term obligations
• Quick Ratio is stricter test of liquidity with inventory
• Solvency measures the ability to survive long term
• Debt to Equity measures grow for growth
• Profitabilty measures include Efficiency and Making money measures

Understand ADA's ADA

• Data extraction reliabilty and issues
• Question of what to do interpretting all data

Auditing Standards Updates

• AICPA auditing standards Type 1 Errors
• Inefficent processes

Audit Sampling

• Differences between it and non statsical.
• Also when each is applicable

Calculation on Sample Size

• Sample error rate and extrapolate

Sampling definition

• Level of the sample and confidenced used.
• Relations and size

Type 1 and 2 erroes

• Hypothesis on balance and type of errors
• Which affects effectiveness