3-1

Chapter Three
Risk Assessment and
Materiality

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 3-2

Audit Risk

The risk that an auditor will issue an

unqualified opinion on materially
misstated financial statements.

Individual account
Financial statement
balance or class
level
of transactions level

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 3-3

Engagement Risk

Client and third

party lawsuits

An auditor’s exposure
to financial loss and
damage to
professional reputation.

Negative
publicity
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 3-4

The Audit Risk Model

Inherent risk and control risk:

Risk that material misstatements exist

Audit Risk = IR × CR × DR

Detection risk:
Risk that auditor will not detect misstatements

• Inappropriate audit procedure

• Fail to detect when using Nonsampling Sampling
appropriate audit procedure risk risk
• Misinterpreting audit results
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 3-5

Using the Audit Risk Model

 Set a planned level of audit risk such that an opinion
can be issued on the financial statements.
 Assess inherent risk and control risk.
 Use the audit risk equation to solve for the appropriate
level of detection risk:

AR = IR × CR × DR
AR
DR = IR × CR

Auditors use this level of detection risk to design audit

procedures that will reduce audit risk to an acceptable level.
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 3-6

Using the Audit Risk Model

Assess the client’s business risks.

Assess the risk of material

misstatement
due to error or fraud.

AR = IR × CR × DR

Auditee risk
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 3-7

Using the Audit Risk Model

Qualitative terms may also be used in the audit risk model.

Case AR IR CR DR
1 Very low High High Low
2 Low Low High Moderate
3 Moderate High Low Moderate

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 3-8

The Auditor’s Risk

Assessment Process

Auditors need to
identify business risks and
understand the potential
misstatements that Business risks
may result. include any external or
internal factors, pressures, and
forces that bear on the entity’s
ability to survive and
be profitable.

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 3-9

The Auditor’s Risk

Assessment Process
Perform risk assessment to obtain understanding of the
entity and its environment, including internal control.

Identify business risks that may result in material

misstatements of the financial statements.

Evaluate the entity’s response to those business

risks and obtain evidence of their implementation.

Assess the risk of material misstatement at the assertion

level and determine the audit procedures that are
necessary based on that risk assessment.
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 3-10

Understanding the Entity

and Its Environment
Financial
Performance

Industry Regulatory
Factors Environment
Objectives and
Strategies

Internal Business
Control Risks
Nature of
the Entity
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 3-11

Auditor’s Risk Assessment

Procedures

Inquiries of
Management
and Others

Analytical Observation
Procedures and Inspection

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 3-12

Identifying Business Risks

Examples of conditions or events that indicate

the existence of business risks:
 Significant changes in the entity (e.g.,
acquisitions and reorganizations).
 Significant changes in the industry.
 Significant new products, services, or lines of
business.
 New locations.
 Significant changes in the IT environment.
 Operations in areas with unstable economies.
 High degree of complex regulation.

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 3-13

Assessing the Risk of Material

Misstatement Due to Error or Fraud
To assess the risk of material misstatement, the auditor:
 Identifies risks by considering the entity and its
environment, including controls that relate to the
risks,and by relating these risks to the classes of
transactions and account balances in the financial
statements.
 Relates the identified risks to what can go wrong at
the assertion level.
 Considers whether the risks are of a magnitude that
could result in a material misstatement.
 Considers the likelihood that the risks will result in a
material misstatement.
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 3-14

Assessing the Risk of Material

Misstatement Due to Error or Fraud
Types of misstatements
 A difference between the amount, classification,
or presentation of a reported financial statement
element, account, or item and the amount,
classification, or presentation that would have
been reported under GAAP.
 The omission of a financial statement element,
account, or item.
 A financial statement disclosure that is not
presented in accordance with GAAP.
 The omission of information required to be
disclosed in accordance with GAAP.
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 3-15

Assessing the Risk of Material

Misstatement Due to Error or Fraud

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.

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 3-16

Assessing the Risk of Material

Misstatement Due to Error or Fraud

Fraud involves
intentional misstatements.

Fraudulent Misappropriation
financial reporting of assets

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 3-17

Assessing the Risk of Material

Misstatement Due to Error or Fraud
Fraudulent financial reporting includes acts such as
the following:
 Manipulation, falsification, or alteration of
accounting records or supporting documents
used to prepare financial statements.
 Misrepresentation in, or intentional omission from,
the financial statements of events, transactions,
or significant information.
 Intentional misapplication of accounting principles
relating to amount, classification, manner of
presentation, or disclosure.

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 3-18

Assessing the Risk of Material

Misstatement Due to Error or Fraud

Misappropriation of assets involves the theft of

an entity’s assets to the extent that financial
statements are misstated. Examples include:

Stealing
assets Paying for
goods and services
not received
Embezzling
cash received

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 3-19

Risk Factors for

Misappropriation of Assets
Access Inadequate
to assets separation No mandatory
of duties vacation policy

Personal Sudden changes in

financial Lack of employee behavior
pressures inventory
control
Adverse
Small, valuable employee management
inventory items relationships

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 3-20

Assessing the Risk of Material

Misstatement Due to Error or Fraud

Three conditions usually

exist when fraud occurs.

Incentive or Opportunity Attitude or

pressure to to commit rationalization
commit fraud fraud to justify fraud

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 3-21

Risk Factors Relating to

Incentive/Pressure
Excessive pressure Excessive pressure
for management to for management to
meet third party meet financial
expectations targets

Financial stability Management’s personal

or profitability financial situation
is threatened is threatened

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 3-22

Risk Factors Relating to

Opportunities

Nature
of the Complex
industry or unstable
organizational
structure
Ineffective
monitoring of
management
Deficient
internal
control
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 3-23

Risk Factors Relating to

Attitudes/Rationalizations

Use of
inappropriate accounting Poor communication
based on materiality channels for reporting
inappropriate behavior

Failure to correct Weak ethical

known reportable standards for
conditions Management
behavior

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 3-24

The Fraud Risk

Identification Process

Discussion Inquiries of
among the management
audit team and others

Sources of
information

Fraud Analytical
risk factors procedures
Other relevant
information
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 3-25

Auditor’s Response to
the Risk Assessment
Assess the risk of material misstatement.

High Determine audit procedures that are Low

risk necessary based on the risk assessment. risk

Evaluate whether sufficient

Design and Design and
audit evidence was
perform perform
obtained and if the
extended normal
procedures. risk assessments procedures.
were appropriate.

Issue audit report.

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 3-26

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.
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 3-27

Materiality

The magnitude of an omission or misstatement of

accounting information that makes it probable that
the judgment of a reasonable person relying on
the information would be changed or influenced
by the omission or misstatement.

Materiality is
a matter of professional
judgment.
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 3-28

Materiality

The quantitative base for

The quantitative amounts
materiality is a percentage
may be adjusted lower for
(typically 3 to 5 percent) of:
qualitative factors such as:
• Total assets.
• First-year engagement.
• Total revenues.
• Control weaknesses.
• Income before taxes.
• Management turnover.
• Income from continuing
• High market pressures.
operations.
• High fraud risk.
• Gross profit
• Higher than normal risk
• Three-year average of
of bankruptcy.
income before taxes.

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 3-29

Steps in Applying Materiality

on an Audit

Establish a preliminary judgment about materiality.

Determine tolerable misstatement.

Estimate likely misstatements and compare

totals to the preliminary judgment about materiality.

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 3-30

End of Chapter 3

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