Unformatted text preview: RISK ASSESSMENT 1 MATERIALITY
• An is considered to be material if the inclusion in the financial statements of that of accounting information would have influenced the decision of a reasonable person who relies on the financial statements. 2 STEPS IN APPLYING MATERIALITY
• • Step 1: Establish a judgment about materiality. Step 2: Allocate the preliminary judgment about materiality to account or class-of . The materiality allocated to the given account balance is referred to as misstatements of that particular balance. Step 3: Estimate the likely misstatement and compare to materiality. • 3 RISK IN AUDITING
• There’s always uncertainty whether the evidence gathered is , the client’s internal is effective, and the financial statements are fairly stated after completing the audit. • Auditors must incorporate these risks into planning the engagement. • Audit risk is the potential that a material misstatements in the financial statements will not be detected by the audit, resulting in the auditor issuing a wrong audit opinion. 4 THE AUDIT RISK MODEL
AAR = Acceptable audit risk IR = Inherent risk CR = Control risk PDR = Planned detection risk The audit risk model is AAR = IR x CR x PDR Or: PDR = AAR/(IR x CR)
5 ACCEPTABLE AUDIT RISK (AAR)
• Acceptable audit risk is the risk the auditor is willing to assume that a material misstatement of the financial statements remains and not reported by the auditor. • Theoretically, risk can fall anywhere in the range given below but as a practical matter it is always greater than . 6 INHERENT RISK (IR)
• Inherent risk is the likelihood, t considering the internal control structure, that a material misstatement will enter the accounting records thereby affecting the financial statements. 7 CONTROL RISK (CR)
• Control risk is the risk that material misstatements will not be prevented or detected on a timely basis by the entity’s . • Assessing control risk at less than 100% requires the control procedures be tested for their effectiveness.
8 • Planned detection risk is the risk that the auditor is willing to take that a material misstatement a tolerable amount has not been detected by the audit. PLANNED DETECTION RISK (PDR) 9 USE OF THE AUDIT RISK MODEL
1. Set a planned level of audit risk. 2. Assess inherent risk and control risk. 3. Solve the audit risk equation for the appropriate level of detection risk. 4. Determine the detection risk and therefore how much evidence must be accumulated. 10 AN EXAMPLE
Set planned audit risk for accounts receivable at .05. Assume further that the auditor assesses inherent risk to be .80 and control risk is 0.60. To determine the level of detection risk for auditing accounts receivable, the audit risk model is solved: AAR = IR x CR x PDR PDR = AAR / (IR x CR) Thus, PDR is set at approximately .10 [PDR = .05/(.80 x .60)] for testing the accounts receivable balance.
11 RELATIONSHIPS AMONG THE COMPONENTS OF RISK
• As AAR increases, PDR increases and planned evidence decreases. • As IR increases, PDR decreases and planned evidence increases. • AS CR increases, PDR decreases and planned evidence increases 12 IMPACT OF BUSINES RISK ON ACCEPTABLE AUDIT RISK
• Auditors face business risk. • Factors affecting acceptable audit risk:
– Degree to which external users rely on the statements. – Likelihood that a client will have financial difficulties after the report is issued. – The auditor’s evaluation of management integrity.
13 FACTORS AFFECTING INHERENT RISK
• • • • • • • Nature of client’s business Integrity of management Results of previous audits Initial versus repeat engagement Related parties Non-routine transactions Judgement required to correctly record transactions • Susceptibility to defalcation 14 LIMITATIONS OF THE MODEL
• AAR, IR and CR are subjectively determined as CPAs often express probabilities in general terms such as high, medium, and low. • The model is a planning model. If upon testing, the IR and CR elements prove to be misspecified, the model should be discarded and sufficient detection procedures performed to provide a high degree of assurance that existing errors have been identified.
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