Audit Risk

• The possibility that the auditors may unknowingly fail

to appropriately modify their opinion on financial
statements that are materially misstated
Audit Evidence – 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 reduce audit risk to a low level in every
audit.

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Financial Statement Assertions: Auditing Standards Board

Financial Statement Assertions and International Standards

• Assertions about account balances (Accounts) Accounts Transactions Disclosures

Existence Occurrence Occurrence
• Assertions about classes of transactions and Rights and Rights and
events (Transactions) obligations obligations
• Assertions about presentation and disclosure Completeness Completeness Completeness

(Disclosures) Valuation and Accuracy Accuracy and

allocation valuation
Cutoff
Classification Classification and
understandability

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1
 Combined Assertions
Used in this Text Audit Risk
• Existence or Occurrence--Assets, liabilities, and equity interests exist
and recorded transactions have occurred
• Rights and Obligations--The company holds rights to the assets, and Risk of Material Risk That the
Audit Risk = Misstatement * Auditors Fail to
liability are the obligations of the company the Misstatement
• Completeness--All assets, liabilities, equity interests, and transactions
that should have been recorded have been recorded
= Inherent Control Detection
• Cutoff—Transactions and events have been recorded in the correct Risk * Risk * Risk
accounting period
• Valuation, Allocation and Accuracy—All transactions, assets, • Inherent Risk--Risk of a material misstatement occurring in an
liabilities and equity interests are included in the financial statements assertion assuming no related internal controls.
at proper amounts
• Control Risk--Risk that a material misstatement in an assertion will
• Presentation and Disclosure--Accounts are described and classified in not be prevented or detected on a timely basis by the company’s
accordance with generally accepted accounting principles, and internal control.
financial statement disclosures are complete, appropriate, and clearly
expressed • 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.

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Audit Risk Formula Audit Risk

Figure 5. 2

AR = IR * CR * DR

AR = Audit risk
IR = Inherent risk
CR = Control risk
DR = Detection risk

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2
 Assertions with high
Inherent Risk
inherent risk
• Factors that affect inherent risk: • Involve:
– Nature of the client and its environment
– Difficult to audit transactions or balances
– Nature of the particular financial statement element
– Complex calculations
• Business characteristics indicative of high inherent risk:
– Inconsistent profitability of client – Difficult accounting issues
– Operating results highly sensitive to economic factors – Significant judgment by management
– Going concern problems
– Large known and likely misstatements detected in prior audits – Valuations that vary significantly based on
– Substantial turnover, questionable reputation, or inadequate economic factors
accounting skills of management

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Types of transactions The Third Field Work Standard

• Routine • Third standard of field work:
– Recurring financial statement activities recorded in the accounting
records in the normal course of business – The auditor must obtain sufficient appropriate audit
– Lower inherent risk evidence by performing audit procedures to perform a
reasonable basis for an opinion regarding the financial
• Nonroutine
statements under audit
– Involve activities that occur only periodically such as the taking of
physical inventories
– High inherent risk • Sufficient audit evidence
• Estimation transactions – The quantity of audit evidence that must be obtained
– Activities that create accounting estimates
– Higher inherent risk

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3
 Appropriateness of Audit Reliability of Certain Types of
Evidence Audit Evidence

• To be appropriate audit evidence must be:

– Relevant RELIABILITY TYPE EXAMPLE
– Reliable High Physical Inventory Observation
• Principles—Audit evidence is ordinarily more reliable
Documentary
when it is External Cutoff Bank Statement
– Obtained from knowledgeable independent sources outside the External/Internal Purchase Invoice
company rather than nonindependent sources Internal Sales Invoice
– Generated internally through a system of effective controls rather
than ineffective controls. Low Client Representations Management Representation
– Obtained directly by the auditor rather than indirectly or by Letter
inference
– Documentary in form rather than oral
– Provided by original documents rather than copies

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Types of Audit Evidence Overall Types of Audit Procedures

Type
Accounting Information System
Documentary evidence
Third-party representations
Physical evidence
Computations
Data interrelationships
Client representations
Example • Risk assessment procedures
The accounting records and support – To obtain an understanding of the client and its
for transactions and journal entries
environment, including its internal control, to assess
Checks, invoices, contracts, minutes
of meetings.
the risks of material misstatement
Confirmations, lawyer’s letters, • Further Audit Procedures
specialist’s reports – Tests of controls
Examination of asset – When appropriate, to test the operating effectiveness of controls in
Footing, recalculations preventing material misstatements
Analytical procedures – Substantive procedures
Representation letter – To detect material misstatements at relevant assertion level.
Substantive procedures include (a) analytical procedures, (b) tests of
details of account balances, transactions and disclosures

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4
 Substantive Procedures
• Analytical procedures
• Tests of details
• Tests of account balances
• Tests of classes of transactions
• Tests of disclosures
– One may change the scope of audit procedures by
changing the (NTE, or re-ordered as NET):
• Nature (type and form)
• Timing (when performed)
• Extent (quantity of evidence obtained)
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Extent of Procedures
Holding other factors such as the nature and
timing of procedures constant:
– The greater the risk of material misstatement, the
greater the needed extent of substantive
procedures
– The main way to increase the extent of audit
procedures is to examine more items
– Sample sizes should reduce detection risk so as to
restrict audit risk to a low level
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Nature and Timing of Procedures
Holding the extent of procedures constant, one
may increase the scope of procedures (make
them more effective) by either changing the
– Nature-- obtain more reliable evidence
• often externally generated evidence.
– Timing--wait until year-end to obtain evidence from entire
set of transactions as contrasted to performing interim
testing, say two months prior to year-end and simply
updating those procedures.
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Analytical Procedures (1 of 2)
• Steps involved
– Develop expectation of account (or ratio) balance
– Determine amount of difference that can be accepted without
investigation
– Compare the company’s account (ratio) with the expectation
– Investigate and evaluate significant differences
• Developing an expectation
– Prior period information
– Anticipated results
– Relationships among elements of financial information within a period
– Industry information
– Relationships between financial information and relevant nonfinancial
data.
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5
 Analytical Procedures (2 of 2) Ratio Analysis
• Types of Expectations • Approaches to ratio analysis
– Trend analysis—analyze changes in accounts of a company – Horizontal analysis
over time • Review ratios over time
– Ratio analysis – compare relationships between two or – Cross sectional analysis
more financial statement accounts or comparisons of
• Analyze ratios of similar firms at a point in time
account balances to nonfinancial data
• Liquidity (e.g., current ratio) – Vertical analysis
• Analyze relationships within a period
• Leverage (e.g., debt to equity)
• “Common size” statements prepared
• Profitability (e.g., gross profit percentage)
• Activity (e.g., inventory turnover) – Other methods
• Regression analysis, reasonableness test

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Identifying Potential Misstatements Basic Approaches to Auditing Accounting

Estimates

• Review and test management’s process

for developing the estimate.
• Independently develop an estimate to
compare to management’s estimate.
• Review subsequent events or
transactions bearing on the estimate.

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 Auditing Fair Values
Related Party Transactions
• Inputs to use in applying valuation techniques (FAS 157)
– Level 1 – inputs of observable quoted prices in active
markets for identical assets or liabilities • Disclosure requirements must be met
• Ex. A closing stock price in WSJ • Primary challenge is identifying undisclosed
– Level 2 – inputs of observable quoted prices, generally
for similar assets or liabilities in active markets related party transactions
• Ex. Company discounts future cash flows on its not publicly – Determine related parties
traded debt securities at rate used by market for publicly
traded debt securities • Inquiries of management
– Level 3 – inputs that are unobservable for the assets or • Review SEC filings, stockholder’s listings and conflict-of-
liability interest statements
• Ex. A private company uses judgment to determine a proper rate to discount
the future cash flows of its not publicly traded securities – Be alert for transactions with related parties and
any transactions with unusual terms

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Functions of Audit Documentation Sufficiency of Audit Documentation

• Primary functions:
•Support the auditors’ compliance with auditing standards
•Support the auditors’ opinion
• Secondary functions:
•Assist continuing and new audit team members in planning
and performing the audit
•Serves as a record of matters of continuing audit interest
•Assists in supervision and review of the audit
•Demonstrates the accountability of team members
•Assists internal reviewers, external peer reviewers, PCAOB
inspectors, and successor auditors in performing their roles
• Audit documentation should be sufficient to:
– Enable an experienced auditor to understand the work
performed and the significant conclusions reached
– Identify who performed and reviewed the work
– Show that the accounting agree or reconcile to the
financial statements
• Audit documentation should include all significant
audit findings and the actions taken to address
them

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 Types of Working Papers Types of Working Files
• Audit administrative working papers
• Working trial balance • Current files
• Lead schedules – Current year working papers
• Adjusting journal entries and reclassification – Index and cross-referencing
entries
• Supporting schedules • Permanent files
• Analysis of a ledger account – Items of continuing audit interest
• Reconciliations
• Computational working papers
• Corroborating documents

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Preparation of a Working Paper – Figure 5.8

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