Chapter 4

Risk Assessment

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Audit Risk

The risk that an auditor expresses

an unqualified opinion on materially

misstated financial statements.

Financial statement

level

Individual account

balance or class

of transactions level

LO# 1

4-2

The Audit Risk Model

Audit Risk = IR × CR × DR

Inherent risk and control risk:

Risk of material misstatement

Nonsampling risk

Sampling risk

Detection risk:

Risk that auditor will not detect misstatements

Inappropriate audit procedure

Fail to detect when using

appropriate audit procedure

Misinterpreting audit results

LO# 2

4-3

Engagement Risk

An auditor’s exposure

to financial loss and

damage to

professional reputation.

Client and third

party lawsuits

Negative

publicity

LO# 2

Local audit

failure …

4-4

Using the Audit Risk Model

Set a planned level of audit risk such that an opinion can be issued on the financial statements.

Assess the risk of material misstatement (IR x CR).

Use the audit risk equation to solve for the appropriate level of detection risk:

AR = IR × CR × DR

DR = AR

IR × CR

Auditors use this level of detection risk to design audit

procedures that will reduce audit risk to an acceptable level.

LO# 3

4-5

Limitations of the

Audit Risk Model

Preliminary

Assessment

Level of Risk

Actual

or Achieved

Level of Risk

LO# 3

+ / –

The audit risk model is a planning tool, but it has some limitations

that must be considered when the model is used to revise an audit

plan or to evaluate audit results.

• The desired level of audit risk may not actually be achieved.

• It does not consider potential auditor error.

• There is no way of knowing what the preliminary level of risk

actually was.

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The Auditor’s Risk Assessment Process Figure 4-2 An Overview of the Auditor’s Assessment of Business Risks and the Risk of

Material Misstatements

LO# 4

4-7

Errors are unintentional misstatements:

Mistakes in gathering or processing financial data used to prepare financial statements.

Unreasonable accounting estimates arising from oversight or misinterpretation of facts.

Mistakes in the application of accounting principles relating to amount, classification, manner of presentation, or disclosure.

LO# 5

Assessing the Risk of Material

Misstatement Due to Error or Fraud

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Fraud involves intentional misstatements. The fraud risk identification process includes:

Sources of information about possible fraud―

Communications among the audit team

Inquires of management and others

Analytical procedures

Unexpected period-end adjustments

LO# 6

Assessing the Risk of Material

Misstatement Due to Error or Fraud

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Three conditions usually

exist when fraud occurs.

Incentive or

pressure to

perpetrate fraud

Opportunity

to carry out

the fraud

Attitude or

rationalization

to justify fraud

LO# 6

Assessing the Risk of Material Misstatement

Due to Error or Fraud

(Fraud Triangle)

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Auditor’s Response to

the Risk Assessment (See Figure 4-3)

Financial statement level risks

Develop an overall

response.

Determine what can go wrong

at the account or assertion level.

LO# 7

Assess the risk of material misstatement at the financial statement and assertion levels.

Do these

risks relate

pervasively to

the financial

statements?

Design audit

procedures for

assertion level risks.

Assertion level risks

Yes

No

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Evaluation of Audit

Test Results At the completion of the audit, the auditor should consider:

1. Whether the accumulated results of audit procedures affect the

assessments of the entity’s business risk and the risk of material

misstatement, and

2. Whether the total misstatements cause the financial statements to be

materially misstated.

THEN …

If the financial statements are materially misstated, the auditor should

1. Request management to eliminate the material misstatement, or

2. If management does not make needed adjustments, the auditor should

issue a qualified or adverse opinion.

LO# 8

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Documentation of the

Auditor’s Risk Assessment The auditor should document:

Discussions among engagement personnel.

Procedures performed to identify and assess the risks

of material misstatement due to fraud.

Risks of identified material misstatement due to fraud

and a description of the auditor’s response to the risks.

Fraud risks or other conditions that result in additional

audit procedures.

The nature of the communications about fraud made to

management, the audit committee, and others.

LO# 9

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Communications about Fraud

Whenever the auditor has found evidence that a fraud may exist,

that matter should be brought to the attention of an appropriate

level of management. Fraud involving senior management and

fraud that causes a material misstatement of the financial

statement should be reported directly to the audit committee of the

board of directors.

The auditor should reach an understanding with the audit

committee regarding the expected nature and extent of

communications about misappropriations perpetrated by lower-

level employees.

LO# 10

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End of Chapter 4

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