Materiality, Risk Assessment, and Internal Control

• Materiality, Risk Assessment, and Internal Control are fundamental aspects of auditing and financial management.

Learning Outcomes

• Understand risk-based audits, internal controls, and risk assessment.
• Identify audit risk and internal control components.
• Review internal control systems.
• Understand the nature, scope, objectives, and structure of internal control systems.
• Report internal control weaknesses to clients.
• Framework for reporting on internal control.
• Practical application of concepts through examples and case studies.

Chapter Overview

• Reporting to clients on internal control weaknesses.
• Audit risk and risk-based audits.
• Internal control system's nature, scope, objectives, and structure.
• Components of internal control.
• Evaluation of internal control systems.
• The process of evaluating internal control systems.
• Internal control and risk assessment.

Materiality and Risk Assessment

• Auditors identify areas prone to misstatements by understanding a company and its internal controls.
• Risk assessment changes due to law changes, business models, or industry shifts, differing from prior years.
• Grasping a company's business risks and strategies impacts audit risk; established risk management plans boost auditor confidence.
• Evaluating company controls pinpoints deficiencies and missing controls.
• Ineffective or absent controls raise the risk of material misstatement, increasing control risk.
• Auditors use risk assessment like inquiries, inspections, and observations to grasp material misstatement risks for an effective audit.
• Auditors communicate internal control deficiencies to management and governance, prompting corrective actions.
• Such communication can serve as auditor's defense by showing preemptive action.
• SA 320 guides auditors in applying materiality when planning, performing audits, and assessing misstatement effects on financial statements and auditor's opinion.
• Throughout the audit, materiality and audit risk are weighed, particularly when spotting and assessing material misstatement risks and determining audit procedure specifics.

Identification of Risks

• Risk assessment gauges risk in various business processes, focusing on business/regulatory environments, organization structure and management concerns to find high-risk areas.
• Auditors address Areas required for Entity Understanding and identify, list events (identified risks) that could result misstatements in financials:
• External Factors
• Nature of Entity
• Entity Objectives & Strategies
• Measurement/review of Financial Performance
• Audit risk means misrepresenting financial statements.
• Audit risk comprises Inherent Risk, Control Risk, and Detection Risk.

Audit Risk Components

• Inherent Risk: Susceptibility of misstatement.
  • Business-related risks affect accountbalance.
  • Complex calculations can be misstated.
  • High-value inventory.
  • Accounting estimates.
  • Insufficient working capital.
  • Technology changes make product obsolete.
• Risks of importance:
  • Complex calculations.
  • High-value inventory.
  • Accounting estimates.
  • Insufficient working capital.
  • Declining or volatile industries.
  • Technological changes.
• Control Risk: Internal control system to prevent errors.
  • Response design mitigates fraud.
  • Entity-level controls impact assertions.
  • Some risk persists despite controls.
• Audit identifies assertions.
  • Auditor should identify material misstatement for procedures and evaluations.
  • Auditors select appropriate procedures and consider misinterpreting info.
• Audit Risk Components Interrelate:
  • Low Risk
  • Moderate Risk
  • High Risk
• Misstatements in financials

Audit Risk Analysis

• Audit Risk (AR) mathematically equals Inherent Risk (IR) x Control Risk (CR) x Detection Risk (DR). i.e. AR = IR x CR x DR.
• Audit Risk has 2 components:
  • Risk of material misstatement -The financial statements contain a material misstatement prior to the audit.
  • Detection risk
    • The auditor will not be able to detect such a misstatement.
• Risk of material misstatement is anticipated ahead of the audit.
• Has two Risk components: Inherent risk and control risk
  • Risk of material Misstatement = Inherent risk X Control risk
• Detection risk: Remaining undetected even if all audit procedures are applied.
• Combined Inherent Risk/Control Risk in Detection Risk.
• Audit Materiality (inverse) related to Audit Risk.
• To reduce audit risk to an acceptable level to state:
  • Assess the risks of material misstatement
  • Limit the detection risk

Assertions

• Auditors assess material misstatement risks in two levels:
  • Risks relate to financial statements, potentially affecting assertions.
• Risks with specific assertions.
• An assessment of risk should be produced to high, moderate, or low.
• Different areas to address are:
  • Occurrence
    • Have been recorded
  • Completeness
    • Should have been recorded
  • Accuracy -Amount that has been appropriated recorded
  • Cut-off
    • Transactions recorded in the correct accounting period.
  • Classification
    • Transactions recorded in proper accounts

Steps for Risk Identification

• significance assessed and materiality revised for specific account balances.
• Likelihood and impact on auditing procedures are determined.
• Assertions documentation.
• Risk impact.
• Significant risks get auditor attention.
• Planned audit procedures.
• The nature of internal controls.
• Routine or periodic controls.
• Error prevention controls.
• Unique risk characteristics.
• Characteristics in transactions.
• Could involve:
  • high value inventory
  • complex contractual agreements
  • customer sales percentage.

Risk-Based Audit Approach

• Risk-based audits addresses audited entity's achievement.
• RBA analyzes audit risks, sets materiality, develops programs that allocate resources to high-risk areas.
• Auditors focus audit procedures on major risks that misstate financial statements.
• Financial audits include assessing misstatement risks.
• Audits helps improve auditee's risk management.
• In performance audits, risks relate to program effectiveness.

Audit Risk Analysis

• Auditors analyze risks impacting auditee before procedures.
• Risk assessment is subjective, based on auditor's judgment.
• Auditors should know whether their opinion fails to appropriately modify statements.

Risks

Include risks about error and fraud

• Error
  • unintentional mistake.
  • legitimate being excluded
• Fraud
  • Users concealing misappropriations.

General Steps

Steps involving risk by following:

• Assessing misstatement risks in financials.
• Designing audit procedures that respond to risks
• Issuing audit report.

Phases

• Risk assessment for client (acceptance/continuance, engagement planning, understanding business, internal controls, assessing risks)
• Risk response with procedure design & evidence collection.
• Reporting and conclusions.

Risk Assessment & Response

Include the following steps taken:

• Acceptance.
• Planning.
• Risk assessment.
• Internal controls.
• Financial misstatements.
• Audit consideration.
• Communicating.
• Informed risk assessment.

Plan

Includes considering considerations:

• No manual intervention.
• Assess control.
• Analytical procedures.
• Risks for management
• Fraud Scenarios
• Identified “significant risks”.

Reporting Phase

The final phase of the audit and is assess what was sufficient to give the most benefit to reduce audit risk. Important determination to consider is:

• Change in assessed the risk level
• Work is always appropriate and followed accordingly
• Suspicious will always be encounter.

The following will also determine

• More assessment can be set appropriately
• Auditors will provide what is required and provide an opinion correctly

Nature, Scope, Objectives and Structure of the Internal Control

• Internal controls gives assurance.
• SA 315 sees the process.

Objectives and compliance

• Set of financials in a true and fair is to check with framework.
• Auditors must gain an understanding.
• The auditor is to obtain evidence
• Auditor should make inquires on several factor.
• The auditor are to consider different control
• Based on set control is determined appropriately.

Components of internal control

• Control environment
• Risk assessment
• Control activities
• Communication
• Monitoring

Control environment encompasses

• Integrity ethical values
• Task and competencies
• Governance consciousness
• Operating style
• Organizational key
• Communication

Objectives related to the effectiveness and efficiency:

• Financial performance and safe guarding assets.
• Reporting
• Established by regulations.

Internal Controls:

• A system
• Accurate recording
• Protected from unorganized use
• Verified appropriate action would be used.

Limitation of Internal Control:

The system must have considerations:

• Costs must expect benefit
• A variety due to error is of human nature and how it acts.
• Through parties to the entity
• The entity will cause any harm.

Structure of Internal Control:

• Segregation is when processing can complete transactions with the completion.
• This will prevent:
• Undetected for too long.
• vested interest from by holding positions for too long
• This also means people understand the data.

Components to be considered of Internal Control to include the follows:

• Control environments.
• Entity's Risk assessment Process.
• Control activities
  • information.
  • responsibility
• Monitoring

Internal Control in nature

• The auditor might obtain audit evidence about the proper segregation of duties.

Internal Control System

It must have the aspects of:

• Clear and well designed and in order.
• To detect easy errors
  • Staff work is with an organization -The integrity, scrutiny is check.
• Also avoid the process with the company’s cash.

The auditors will check for different things:

-Financial and administrative is to be correctly distributed

• Check account is very accurate.

Internal audits

• It will the scope is set by the management system
• The company must reflect the process
• By what they act and plan.

system

• Designed to check errors is to effectively or not
• With these action in control:
  • Procedures is to work
• Assess performance and monitor.

System is to be as the follows

• That needs to address
• Need that includes test to mitigate or add to acceptable low level
• And a audit report by findings.

Effectiveness will fall depending

• By what and consistency
• With internal controls
• How has the system done.

Review of the System of Internal Controls

The steps are:

• Opinion is what can be put for reliance. -The nature, timing and extent must adjust.

Assessment Evaluation

For more assessment on key note see:

• Well communication.
• Risk can be reduced. -The duties of the job and what must occur.
• A buyer won’t receive or pass items.

Techniques Evaluation

• The goal and the questions are needed to get better
• However it can be hard
• For the client there can be many questions on their own.

Standard Controls in place;

• All procedures must work
• It is important on a team as one self.
• No sole person one the position and for completing by them self
• Always know if authorize as one as the position
• Work is always looked and will work fine.

Chart Flow:

• In sections or different types to see the overall.
• To analyze what they should know
• What will the process steps be taken
• To make an chart:
• See what's need and make by sections
• Know were it has come from and what can be seen.

Reporting to Clients on Internal Control Weaknesses;

• Auditors note material internal control weaknesses that increase fraud possibilities in financials. Letter components will:
• List in detail where the weaknesses affect the system
• Clearly state discuss management.
• What the auditor should not assume or try.

The auditor must communicate;

• To also write letters To look for defects.