Chapter 6 Power Points_Risk Assessment.pptx

Chapter 6 Risk Assessment 5-1 RISK ASSESSMENT Risk assessment procedures To obtain an understanding of the client and its environment, including its internal control, to assess the risks of material misstatement...

Chapter 6 Risk Assessment 5-1 RISK ASSESSMENT Risk assessment procedures To obtain an understanding of the client and its environment, including its internal control, to assess the risks of material misstatement 5-2 AUDIT RISK FORMULA AR = IR * CR * DR AR = Audit risk IR = Inherent risk CR = Control risk DR = Detection risk 5-3  AUDIT RISK Risk of Material Risk Auditors Fail Audit Risk = Misstatement to Detect Material Misstatement = Inherent Control Detection Risk Risk Risk 5-4  UNDERSTANDING THE CLIENT’S BUSINESS & ENVIRONMENT (INHERENT RISK) Competitive position Organizational structure Accounting policies and procedures Ownership Capital structure Product and service lines Critical business processes Internal control Supplier and customer relationships Technology developments Major laws and regulations Economic conditions 5-5 INHERENT RISK Inherent Risk Risk of a material misstatement occurring in an assertion assuming no related internal controls. Factors that affect inherent risk: Nature of the client and its environment Nature of the particular financial statement element 5-6 ASSERTIONS WITH HIGH INHERENT RISK Involve: Difficult to audit transactions or balances Complex calculations Significant judgment by management Inconsistent profitability of client Operating results highly sensitive to economic factors Going concern problems Large known and likely misstatements detected in prior audits Substantial turnover, questionable reputation, or inadequate accounting skills of management 5-7 UNDERSTANDING THE CLIENT’S BUSINESS — INTERNAL CONTROL Need knowledge and understanding of how a client’s internal control works: What controls exists Who performs them How various types of transactions are processed and recorded What accounting records and supporting documentation exist 5-8 CONTROL RISK Risk that a material misstatement in an assertion will not be prevented or detected on a timely basis by the company’s internal control. TOD – Test of Design TOE – Test of Effectivness 5-9 DETECTION RISK Risk that the auditors’ procedures will lead them to conclude that a material misstatement does not exist in an assertion when in fact such misstatement does exist. Auditors work and procedures 5-10  Analytical procedures SUBSTANT IVE Tests of details PROCEDU Tests of account balances Tests of classes of transactions RES Tests of disclosures One may change the scope of audit “MORE procedures by changing the (NTE, or re-ordered as NET): WORK” Nature (type and form) Timing (when performed) Extent (quantity of evidence obtained) 5-11 APPROPRIATENESS OF AUDIT EVIDENCE Auditor must obtain sufficient appropriate audit evidence. To be appropriate audit evidence must be: Relevant Reliable Principles—Audit evidence is ordinarily more RELIABLE when it is Obtained from knowledgeable independent sources outside the company rather than nonindependent sources Generated internally through a system of effective controls rather than ineffective controls. Obtained directly by the auditor rather than indirectly or by inference Documentary in form rather than oral Provided by original documents rather than copies 5-12 AUDIT RISK The possibility that the auditors may unknowingly fail to appropriately modify their opinion on financial statements that are materially misstated This is the risk that the auditors will issue an unqualified opinion on financial statements that contain a material departure from GAAP. Auditors must obtain sufficient appropriate audit evidence to 5-13 Audit Risk Figure 5.2 5-14  ASSESSING FRAUD RISKS Two types Fraudulent financial reporting (management fraud) Misappropriation of assets (defalcations) Procedures to assess fraud risks Discussion among engagement team – “brainstorming session” Inquiries of management and other personnel Risk assessment analytical procedures (to aid in planning the audit) Considering fraud risk factors Incentives Opportunity Attitude 5-15 RESPONDING TO FRAUD RISKS Overall response Professional skepticism and audit evidence Assigning personnel and supervision Accounting principles Predictability of auditing procedures Alterations in audit procedures More reliable evidence Shifting timing to year end Increasing sample sizes Response to the possibility of management override Examining journal entries Review accounting estimates for biases Evaluating the business rationale for significant unusual transactions 5-16