Framework Step 3: Identify and Assess Risks of Material Misstatement for the Accounting Estimate

Figure 3.2: Process for Identifying Risks of Material Misstatement (A)

3.1.1: Identify Risks of Misstatement

Using the information obtained from our risk assessment procedures, including the audit evidence obtained in
understanding relevant controls (i.e., evaluating the design of relevant controls and determining whether
they have been implemented), we identify the risks of misstatement related to accounting estimates. In this
context, risks of misstatement do not represent all possibilities of any misstatement of any magnitude, but
rather those risks or risk factors that we believe require further consideration to determine whether they
have the potential to give rise to misstatements that, individually or in aggregate, could material misstate
the financial statements and which therefore may be risks of material misstatement. Our ultimate goal is to
identify risks of material misstatements. However, risks of misstatement are considered in order to help us
form the appropriate basis to support our identification of a complete population of risks of material
misstatement applicable to the financial statements being audited. Most accounting estimates may have
multiple risks of misstatement.

Note A potential pitfall when identifying risks of misstatement is to consider all possible risks related
to a particular account balance or disclosure to be risks of misstatement instead of identifying
just those risks that have the potential to cause misstatements that would be material to the
financial statements. Not all risks will have the potential to cause a material misstatement
and, therefore, we would not identify all of them as risks of misstatement.

The risk assessment procedures we perform provide the audit evidence necessary to support the
identification of risks of misstatement and our assessment of such risks (including the identification of which
identified risks are ultimately identified as risks of material misstatement, and assessed as lower, higher, or

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Framework Step 3: Identify and Assess Risks of Material Misstatement for the Accounting Estimate

significant). Therefore, the results of our risk assessment procedures are an integral part of the audit
evidence we obtain to support our opinion on the financial statements.

Note The explicit requirement to identify “risks of misstatement” exists in the PCAOB AAM
[PCAOB AAM 13150.3(a)]; however, our audit approach requires that we “identify risks….by
considering what can go wrong” [AAM 13150.4(a)], which we interpret to mean the same
as identifying risks of misstatement and an interim step to our identification of the risks of
material misstatement. Therefore, the process of identifying risks of misstatement and the
assessment of which risks are risks of material misstatement is considered foundational to
the risk assessment process under our audit approach (i.e., we believe the process of
considering risks of misstatement is a stepping stone between the identification of risks and
risk factors and our identification of the risks of material misstatement).

As discussed in Framework Step 1, "Identify Accounting Estimates," Figure 3.3 that follows illustrates the
population of risks and risk factors that we considered while performing our risk assessment procedures
related to accounting estimates, and which may or may not represent risks of misstatement.

Figure 3.3: Risks and Risk Factors

In order to identify risks of misstatement related to accounting estimates, we consider and use the
information gathered from the procedures described in Framework Step 1, "Identify Accounting Estimates,"
and Framework Step 2, "Understand How Management Makes the Accounting Estimate." In doing so, we
eliminate the risks and risk factors that, when considered individually or in the context of all the information
collected through risk assessment procedures, do not reasonably present a risk of misstatement that needs
further evaluation. Using professional judgment, at this point it will likely be relatively easy to conclude that
some or many risks and risk factors are not risks of material misstatement; the remaining population are
risks of misstatement, which are a subset of the risks and risk factors considered (represented by the white
circle in Figure 3.4).

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Framework Step 3: Identify and Assess Risks of Material Misstatement for the Accounting Estimate

Figure 3.4: Risks of Misstatement

Note For many risks or risks factors, it is likely that we may be able to conclude that the risk
does not present a risk of misstatement and, therefore, further evaluation of the risk to
understand if it presents a risk of material misstatement is not needed. Often these
judgments may occur with very little effort.

For example, virtually all consumer product entities could be subject to

product liability claims, so the exposure to product liability claim liabilities
would likely give rise to one or more risks of misstatement for most entities.
For many entities, however, the nature of the products sold by the entity and
a history of no such claims might allow us to easily determine these risks do
not represent a risk of material misstatement.

Generally, our documentation of our risk assessment procedures, as well as the risks of
material misstatement included in our RoMM working papers (or equivalent documentation)
or in the risk strategy view of EMS, will provide sufficient documentation to support our risk
assessment; this includes risks at both the financial statement level and assertion level.

For audits performed using the PCAOB AAM, the documentation of our risk assessment
procedures is required to include a summary of the identified risks of misstatement and the
auditor’s assessment of risks of material misstatement at the financial statement and
assertion levels (PCAOB AAM 12000.32). Our risk assessment will likely result in most risks
of misstatement identified as being determined to be risks of material misstatement. When,
on the basis of evidence from risk assessment procedures, risks of misstatement are
concluded not to present risks of material misstatement, the audit documentation includes
support for the professional judgments, documented in a manner sufficient to enable an
experienced auditor, having no previous connection to the audit, to understand the
conclusions reached. Due to these assumptions, as supported by the evidence from the
performance of risk assessment procedures, separate documentation identifying the risks of
misstatement generally is not needed in the audit working papers to comply with this
requirement. See Section 3.4, "Documentation Considerations," for further discussion.

For example, as part of our risk assessment procedures performed in Framework Step 1, "Identify
Accounting Estimates," and in understanding the entity’s selection of accounting principles related to
revenue recognition, we identified that the entity is engaged in long-term construction-type contracts
and uses the percentage of completion method. As a result, we identified the potential for the financial

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Framework Step 3: Identify and Assess Risks of Material Misstatement for the Accounting Estimate

statements to be materially misstated due to inappropriate amounts of revenue being recognized. We

believe that there are one or more risks of misstatement related to this revenue stream that need to be
further assessed to determine whether they are risks of material misstatement, because of the
complexity and size of the account.

For example, as part of our risk assessment procedures performed in Framework Step 1, "Identify
Accounting Estimates," we obtained evidence that the entity received notification from a regulatory
agency indicating its identification as a potentially responsible party pursuant to enforcement actions.
The amounts involved appear to be substantial and no liability is currently recorded. As a result, we
identified the potential for the financial statements to be materially misstated as a result of non-
recognition of a liability for the environmental obligation, measuring the liability at an inappropriate
amount, or inadequate disclosures. We believe there are one or more risks of misstatement related to
this accounting estimate that need to be further assessed to determine whether they are risks of
material misstatement.

For example, as part of our risk assessment procedures performed in Framework Step 2, "Understand
How Management Makes the Accounting Estimate," and in understanding management’s process for
determining employee benefit obligations, we discovered that management has been offering plan
participants lump-sum settlement payments related to their vested pension rights. As a result, we
identified the potential for the financial statements to be materially misstated as a result of incomplete
or non-recognition of liabilities related to the entity’s estimated pension benefit obligations associated
with the settlements, measurement of the various components of the pension liabilities at inappropriate
amounts, or inadequate disclosures. We believe there are one or more risks of misstatement related to
this accounting estimate that need to be assessed to determine if they are risks of material
misstatement.

Note It is important to note that a seemingly immaterial accounting estimate may have the
potential to result in a material misstatement resulting from estimation uncertainty (i.e., the
size of the amount recognized or disclosed in the financial statements for an accounting
estimate may not be an indicator of its estimation uncertainty) (PCAOB AAM 23004.57 or AAM
23004.57).

When identifying risks of misstatement, we are concerned with risks related to financial reporting; however,
business risks may also give rise to financial reporting risks. We may have identified these broader business
risks during Framework Step 1, "Identify Accounting Estimates," or Framework Step 2, "Understand How
Management Makes the Accounting Estimate." We may consider these broader business risks to help us
identify risks that have the potential for causing an accounting estimate to be materially misstated.

For example, in connection with our discussions with management related to changes to the business from
the prior year, we were informed that as part of an effort to increase profitability (the entity's business
objective), management decided to change its practices relating to the extension of credit, such that credit is
now being extended to customers that would not have qualified for credit under historical practices.

This is a business strategy designed to drive more revenue and profitability (i.e., a measured business risk
that management has undertaken), but the new strategy may cause us to conclude that there is the
possibility of new or increased (as compared to prior year) risks relating to valuation of receivables that could
cause the financial statements to be materially misstated (e.g., due to the non-recognition of an allowance
for doubtful accounts related to receivables from these new customers that may have higher credit risk), or
the recorded allowance being inadequate. For example, if those responsible for estimating the allowance for
doubtful accounts or for reviewing the process and the outcome are not aware of, or do not properly consider
the effects of, the new credit policy, the estimate of the allowance for doubtful accounts has the potential to
be misstated such that the financial statements could be materially misstated (financial reporting risk).

For example, we are aware that the entity is in a period of significant growth, achieved largely through a
series of acquisitions that have been made throughout the United States. As part of this business strategy,

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