Learning Objectives

1. Chapter 7Planning the Audit: Identifying and Responding to the Risks of Material Misstatement

2. Learning Objectives • Define the concept of material misstatement and discuss the importance of materiality judgments in the audit context • Identify the risks of material misstatement and describe how they relate to audit risk and detection risk • Assess factors affecting inherent risk • Assess factors affecting control risk

3. Learning Objectives • Use preliminary analytical procedures and brainstorming to identify areas of heightened risk of material misstatement • Describe how auditors make decisions about detection risk and audit risk

4. Learning Objectives • Respond to the assessed risks of material misstatement and plan the procedures to be performed on an audit engagement • Apply the frameworks for professional decision making and ethical decision making to issues involving materiality, risk assessment, and risk responses

5. THE AUDIT OPINION FORMULATION PROCESS

6. PROFESSIONAL JUDGMENT IN CONTEXT - Risks Associated with Financial Statement Misstatements • Risk: Expresses uncertainty about events and/or their outcomes having a material effect on the organization • According to ISA 315 the risks: • Are associated with operational and financial reporting decisions • Are sometimes hard to quantify and are judgmental in nature • Are present but the organization does not have material misstatements, thus making it difficult for auditors to know when a risk factor truly is leading to a material misstatement for their particular clients

7. PROFESSIONAL JUDGMENT IN CONTEXT - Risks Associated with Financial Statement Misstatements • What conditions would cause these types of risks to lead to a material misstatement in the financial statements? (LO 1, 2, 3, 4, 5) • What types of risks do these examples represent? (LO 2, 3, 4) • How do these risks affect detection risk and audit risk? (LO 2, 7)

8. Learning Objective 1 Define the concept of material misstatement and discuss the importance of materiality judgments in the audit context

9. Assessing Materiality • Misstatement: An error, either intentional or unintentional, that exists in a transaction or financial statement account balance • Essential to understand materiality in the context of designing and conducting a quality audit

10. Assessing Materiality

11. Assessing Materiality • According to ISA 320, Materiality in Planning and Performing an Audit • Auditors’ judgments about materiality should be made based on a consideration of information needs of users as an overall group • According to the Supreme Court of the United States • Fact should be viewed by reasonable investors as having significantly altered total mix of information made available

12. Materiality Guidance • Audit firms provide auditors with: • Specific written guidance • Decision aids • Levels considered by auditors • Materiality for the financial statements as a whole • Performance materiality for particular classes of transactions, account balances, or disclosures

13. Materiality Guidance • Performance materiality: Amount set by auditor at less than materiality level for financial statements as a whole or for particular classes of transactions, account balances, or disclosures • Used to: • Assess risks of material misstatement • Determine the nature, timing, and extent of audit procedures

14. Materiality Guidance • Tolerable misstatement: Amount of misstatement in an account balance that the auditor could tolerate and still not judge underlying account balance to be materially misstated • Clearly trivial amount (posting materiality) • Inconsequential, whether: • Taken individually or in the aggregate • Judged by any criteria of size, nature, or circumstances

15. SEC Views on Materiality • Criticisms of the auditing profession • Netting material misstatements • Not applying materiality concept to swings in accounting estimates • Consistently passing on individual adjustments that may not be considered material

16. SEC Views on Materiality • Qualitative reasons for considering quantitatively small misstatement material • Hiding failure to meet analysts’ consensus expectations • Changing a loss into income, or vice versa • Concerning a segment playing significant role in operations or profitability • Affecting compliance with regulatory requirements • Affecting compliance with loan covenants • Effecting the increases in management’s compensation

17. Situations necessitating Change in Materiality Judgments • Initial materiality judgments were based on estimated or preliminary financial statement amounts, which are different from the audited amounts • Financial statement amounts initially used in the making of materiality judgments have changed

18. Changes in Materiality Judgments • Auditors make professional judgments about size of material misstatements providing a basis for: • Determining nature and extent of risk assessment procedures • Identifying and assessing risks of material misstatement • Determining nature, timing, and extent of tests of controls and substantive audit procedures

19. Learning Objective 2 Identify the risks of material misstatement and describe how they relate to audit risk and detection risk

20. EXHIBIT 7.1 - Risks Relevant to an Audit

21. risk of material misstatement • Exists at the financial statement level and assertion level • Categories of risk within these levels • Inherent risk • Control risk • Risk of material misstatement high - Auditor accepts less audit risk • Risk of material misstatement lower - Auditor accepts more audit risk

22. risk of material misstatement • Detection risk: Level of audit effort that auditor will expend on engagementdepends on level of detection risk When risk of material misstatement is higher Detection risk is set lower Increase in evidence obtained through substantive audit procedures

23. Auditing in Practice - What Makes a Risk Significant? • AU-C 315: • Whether the risk is a risk of fraud • Whether the risk is related to recent significant economic, accounting, or other developments and, requires specific attention • Complexity of transactions • Whether the risk involves transactions with related parties • Degree of subjectivity in measurement of financial information related to risk • Whether the risk involving significant transactions outside normal course of business

24. Learning Objective 3 Assess factors affecting inherent risk

25. factors FOR assessment of inherent risk at the assertion level at a higher level • Account represents an asset that can be easily stolen • Account balance made up of complex transactions • Account balance requires a high level of estimation to value • Account balance subject to adjustments that are not in the ordinary processing routine • Account balanced composed of a high volume of nonroutine transactions

26. Business Risks • Inherent risk at financial statement level that affects business operations and potential outcomes of organizational activities • Factors affecting such risk • Overall economic climate • Technological changes • Competitor actions • Geographic locations of suppliers

27. factors For assessment of inherent risk of operations at higher level • Lack of expertise to deal with changes in industry • Uncertain likelihood of successful introduction of new product and acceptance by market • Information technology being incompatible across systems • Expansion of business for which demand not accurately estimated • Implementation of incomplete business strategy • New regulatory requirements increase legal exposure

28. factors For assessment of inherent risk of operations at higher level • Alternative products, services, competitors, or providers posing a threat to current business • Significant supply chain risks • Complex production and delivery processes • Mature and declining industry • Inability to control costs with possibility of unforeseen costs • Producing products that have multiple substitutes

29. Sources of Information for Assessing Business Risks • Management inquiries • Review of client’s budget • Tour of client’s plant and operations • Review government regulations and client’s legal obligations • Knowledge management systems • Online searches • Review of SEC filings • Company Web sites • Economic statistics • Professional practice bulletins • Stock analysts’ reports • Company earnings calls

30. Inherent Risk at Financial Statement Level - Financial Reporting Risks • When assessing this risk, auditors consider all items on a company’s financial statements that are subjective and based on judgment • Inherent risk at the financial statement level is affected by: • Competence and integrity of management • Potential incentives to misstate the financial statements

31. Sources of Information Regarding Management Integrity • Predecessor auditor • Other professionals in business community • Other auditors within audit firm • News media and Web searches • Public databases • Preliminary interviews with management • Audit committee members • Inquiries of federal regulatory agencies • Private investigation firms

32. Auditing in Practice - anExample of Inherent Risk at Financial Statement Level • Former CFO of Maxim Integrated Products was held liable for securities fraud for engaging in a scheme to backdate stock option grants • Aided Maxim’s failure to maintain accurate accounting records, resulting in inaccurate financial reporting • Management integrity was a fundamental problem leading to this fraud • Assessing management integrity is no easy task

33. factors for assessment of inherent risk of financial reporting at higher level • Discrepancies in accounting records • Unusual relationships between auditor and management • Lack of management competence • Company history of meeting analyst estimates or high earnings growth expectations • An impending initial public offering of stock • Disagreements over financial reporting with prior auditors • Auditor resignation • Unusual transactions with outsiders or significant related party transactions

34. factors for assessment of inherent risk of financial reporting at higher level • Transactions for which most of the revenue or expense is recognized at inception of transaction • Financial results that seem too good to be true • Complex business arrangements that serve little practical purpose • Evasiveness from management regarding questions about financial statements • Insistence by CEO or CFO to be present at all meetings • Accounting methods appearing to favor form over substance

35. Auditing in Practice - Application of Accounting Principles and Related Disclosures • Auditor needs to: • Determine whether management’s decisions are appropriate and consistent with financial reporting framework • Develop expectations about appropriate disclosures that are necessary • Compare those expectations to disclosures made by management in assessing inherent risks

36. Learning Objective 4 Assess factors affecting control risk

37. Control Risk • Relates to susceptibility that a misstatement will not be prevented or detected on a timely basis by internal control system • It’s assessment can be made at: • Overall financial statement level • Account or assertion level

38. Assessing Factors Affecting Control Risk • Poor controls in specific countries or locations • Difficulty gaining access to the organization or determining the controllers of the organization • Little interaction between senior management and operating staff • Weak tone at the top leading to a poor control environment • Inadequate accounting staff and information systems

39. Assessing Factors Affecting Control Risk • Growth of organization exceeding accounting system infrastructure • Disregard of regulations for prevention of illegal acts • No internal audit function, or lack of respect for internal audit function by management • Weak design, implementation, and monitoring of internal controls • Lack of supervision of accounting personnel

40. Auditing in Practice - Lack of Oversight as a Control Weakness Leads to Embezzlement • Rita Crundwell and the City of Dixon, Illinois • $50+ million fraud • Auditors need to be aware of weak internal controls and negative consequences for a client’s financial statements • Control risk assessment as high means a need to perform additional substantive procedures • Assessment of control risk as low means a need to test those controls for operational efficiency

41. TECHNIQUES TO UNDERSTANDING MANAGEMENT’S RISK ASSESSMENT • Understand processes used by the board and management to manage risk • Review risk-based approach used by internal audit function with its director and audit committee • Interviewing management about: • Risk approach • Risk preferences • Risk appetite • Relationship of risk analysis to strategic planning

42. TECHNIQUES TO UNDERSTANDING MANAGEMENT’S RISK ASSESSMENT • Review outside regulatory reports • Review company policies and procedures • Review company compensation schemes • Review prior years’ work • Determine how management and board: • Monitor risk • Identify changes in risk • React to mitigate, manage, or control the risk

43. Learning Objective 5 Use preliminary analytical procedures and brainstorming to identify areas of heightened risk of material misstatement

44. Preliminary Analytical Procedures Developing an expectation Determining when the difference between auditor’s expectation and client’s records would be significant Computing that difference Following up on significant differences

45. Types of Analytical Techniques • Trend analysis: Based on the history of changes in the account, year-to-year comparisons of: • Account balances • Graphic presentations • Analysis of financial data • Histograms of ratios • Projections of account balances

46. Types of Analytical Techniques • Ratio analysis: Identifies significant differences between the client results and a norm or between auditor expectations and actual results • Identifies potential audit problems that may be found in ratio changes between years

47. EXHIBIT 7.3 - Commonly Used Ratios

48. Ratio and trend analysis • Carried out through a comparison of client data with expectations: • Based on industry data • Based on similar prior-period data • Developed from industry trends, client budgets, other account balances, or other bases of expectations

49. Brainstorming • Agroup discussion designed to encourage auditors to creatively assess client risks • Particularly those relevant to possible existence of fraud in an organization • Occur during the early planning phases of audit • Repeated if actual fraud is detected • Attended by entire engagement team and led by audit partner or manager

50. guidelines followed during brainstorming session