Johnstone_9e_Auditing_Chapter7_PPtFINAL.pdf

A U D I T I N G A RISK-BASED APPROACH TO

CONDUCTING A QUALITY AUDIT

9th Edition

Karla M. Johnstone | Audrey A. Gramling | Larry E. Rittenberg

Copyright © 2014 South-Western/Cengage Learning

CHAPTER 7 PLANNING THE AUDIT: IDENTIFYING AND RESPONDING TO THE RISKS OF MATERIAL

MISSTATEMENT

Copyright © 2014 South-Western/Cengage Learning 7-2

LEARNING OBJECTIVES

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

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

3. Assess factors affecting inherent risk 4. Assess factors affecting control risk


LEARNING OBJECTIVES

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

6. Describe how auditors make decisions about detection risk and audit risk


LEARNING OBJECTIVES

7. Respond to the assessed risks of material misstatement and plan the procedures to be performed on an audit engagement

8. Apply the frameworks for professional decision making and ethical decision making to issues involving materiality, risk assessment, and risk responses


THE AUDIT OPINION FORMULATION PROCESS


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


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)

DEFINE THE CONCEPT OF MATERIAL MISSTATEMENT AND DISCUSS THE IMPORTANCE OF MATERIALITY

JUDGMENTS IN THE AUDIT CONTEXT

L E A R N I N G O B J E C T I V E 1


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



•Magnitude of an omission or misstatement of accounting information that, in view of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement

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


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



• 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



• 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


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


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


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


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

IDENTIFY THE RISKS OF MATERIAL MISSTATEMENT AND DESCRIBE HOW THEY

RELATE TO AUDIT RISK AND DETECTION RISK



EXHIBIT 7.1 - RISKS RELEVANT TO AN AUDIT


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


RISK OF MATERIAL MISSTATEMENT

• Detection risk: Level of audit effort that auditor will expend on engagement depends 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


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

ASSESS FACTORS AFFECTING INHERENT RISK



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


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


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


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


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


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


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


AUDITING IN PRACTICE - AN EXAMPLE 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


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


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


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

ASSESS FACTORS AFFECTING CONTROL RISK



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


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


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


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


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


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

USE PRELIMINARY ANALYTICAL PROCEDURES AND BRAINSTORMING TO IDENTIFY AREAS OF

HEIGHTENED RISK OF MATERIAL MISSTATEMENT



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


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


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


EXHIBIT 7.3 - COMMONLY USED RATIOS


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


BRAINSTORMING

• A group 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


GUIDELINES FOLLOWED DURING BRAINSTORMING SESSION

Suspension of criticism

Freedom of expression

Quantity of idea generation

Respectful communication


STEPS IN BRAINSTORMING SESSIONS

Reviewing prior year client information

Considering client information, particularly with respect to the fraud triangle

Integrating information from previous steps into an assessment of likelihood of fraud in engagement

Identifying audit responses to fraud risks

DESCRIBE HOW AUDITORS MAKE DECISIONS ABOUT DETECTION RISK AND AUDIT RISK



DETERMINING DETECTION RISK AND AUDIT RISK

• Auditor determines level of detection risk on the basis of: • Assessment of risk of material misstatement at all

levels • Consideration of desired level of audit risk

• Determining detection risk influences nature, amount, and timing of substantive audit procedures


DETECTION RISK AND AUDIT RISK

• Detection risk is affected by: • Effectiveness of substantive auditing procedures

performed • Extent to which the procedures were performed with

due professional care • High level of detection risk

• Audit firm is willing to take higher risk of not detecting a material misstatement

• Audit risk is also high


DETECTION RISK AND AUDIT RISK

• Low level of detection risk • Audit firm is not willing to take as much of a risk of not

detecting material misstatement • Audit risk is also low

• Audit risk usually set at between 1% and 5% • Detection risk ranges from 1% to 100%


EXHIBIT 7.4 - RISKS AND THEIR EFFECTS ON AUDIT WORK


EXHIBIT 7.4 - RISKS AND THEIR EFFECTS ON AUDIT WORK


HIGH RISK OF MATERIAL MISSTATEMENT

• Assuming an account with many complex transactions and weak internal controls • Inherent risk and control risk assessed at their

maximum • Audit risk set at a low level

• Audit risk model Audit Risk = Inherent Risk × Control Risk × Detection Risk

0.01 = 1.00 × 1.00 × Detection Risk Detection Risk = 0.01 / (1.0 × 1.0) = 1%


LOW RISK OF MATERIAL MISSTATEMENT

• Assuming an account with simple transactions and well-trained personnel with no incentive to misstate financial statements • Inherent risk and control risk assessed at 50% and 20%

respectively • Audit risk set at 5%

Audit Risk = Inherent Risk × Control Risk × Detection Risk

0.05 = 0.50 × 0.20 × Detection Risk Detection Risk = 0.05 / (0.50 × 0.20) = 50%


AUDITING IN PRACTICE - AN EXPANDED VERSION OF AUDIT RISK MODEL

RESPOND TO THE ASSESSED RISKS OF MATERIAL MISSTATEMENT AND PLAN THE PROCEDURES TO

BE PERFORMED ON AN AUDIT ENGAGEMENT



PLANNING AUDIT PROCEDURES TO RESPOND TO THE ASSESSED RISKS OF MATERIAL MISSTATEMENT

• Auditor should design: • Controls reliance audit • Substantive audit

• When considering risk responses, auditor should: • Evaluate reasons for assessed risk of material

misstatement • Estimate likelihood of material misstatement due to

inherent risks of client


PLANNING AUDIT PROCEDURES TO RESPOND TO THE ASSESSED RISKS OF MATERIAL MISSTATEMENT

• Consider the role of internal controls, and determine whether control risk is relatively high or low

• Obtain more relevant and reliable evidence with increase in assessment of risk of material misstatement


EXHIBIT 7.5 - EFFECT OF RISK ASSESSMENT ON RISK RESPONSE


NATURE OF RISK RESPONSE

• Types of audit procedures applied given the nature of account balance and relevant assertions regarding that account balance • Procedures

• Assembling audit team with more experienced auditors • Including on audit team outside specialists • Increasing emphasis on professional skepticism


TIMING OF RISK RESPONSE

• When audit procedures are conducted and whether they are conducted at announced or predictable times

• When risk of material misstatement is heightened • Audit procedures conducted closer to year end on an

unannounced basis • Some element of unpredictability included in timing



• Introducing unpredictability • Performance of some audit procedures on low risk

accounts, disclosures, and assertions • Change in timing of audit procedures from year to year • Selection of items for testing that are lower than prior-

year materiality • Performance of audit procedures on a surprise or

unannounced basis • Varying location or procedures year to year



• Procedures that can be completed only at or after period end • Comparison of financial statements to accounting

records • Evaluation of adjusting journal entries made by

management in preparing financial statements • Conduct procedures to respond to risks that

management may have engaged in improper transactions at period end


EXTENT OF RISK RESPONSE

• Amount of evidence that is necessary given client’s assessed risks, materiality, and level of acceptable audit risk • When risk of material misstatement is heightened,

auditor increases extent of audit procedures and demands more evidence


AUDITING IN PRACTICE - THE CITY OF DIXON, ILLINOIS SUES ITS AUDITOR RELATED TO RITA CRUNDWELL

EMBEZZLEMENT

• The lawsuit alleges: • Professional negligence • Negligent misrepresentation • Certain deficiencies in audit procedure

• Severe consequences to all parties involved • When auditors fail to assess and appropriately respond

to risk of material misstatement

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