ASSESSING

THE RISK OF
MATERIAL
MISSTATEMENT
CHAPTER 9

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 CHAPTER 9 LEARNING OBJECTIVES
9-1 Define risk in auditing.
9-2 Distinguish the different types of risk assessment procedures.
9-3 Understand important auditor considerations related to the risk of material
misstatement due to fraud.
9-4 Describe the auditor’s responsibility to identify significant risks.
9-5 Describe the audit risk model and its components.
9-6 Assess acceptable audit risk.
9-7 Consider the impact of several factors on the assessment of inherent risk.
9-8 Discuss the relationship of risk to audit evidence.
9-9 Discuss how materiality and risk are related and integrated into the audit
process.

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 OBJECTIVE 9-1
Define risk in auditing.

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 DEFINE RISK IN AUDITING

• Auditors accept some level of risk or uncertainty in performing audits.

• Risk of Material Misstatement at the Overall Financial Statement
Level: Refers to the risks that relate pervasively to the financial
statements as a whole and potentially affect a number of different
transactions and accounts.
• Risk of Material Misstatement at the Assertion Level: There are two
components to risk at the assertion level:
1. Inherent risk—Susceptibility of an assertion to material
misstatement.
2. Control risk—Risk that internal controls will not prevent or detect
material misstatement.

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 OBJECTIVE 9-2
Distinguish the different types
of risk assessment procedures.

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 RISK ASSESSMENT PROCEDURES

Risk assessment procedures include the following:

1. Inquiries of management and others within the entity
2. Analytical procedures
3. Observation and inspection
4. Discussion among engagement team members
5. Other risk assessment procedures

The role of risk assessment procedures is detailed in Figure 9-1.

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 OBJECTIVE 9-3
Understand important auditor
considerations related to the risk of
material misstatement due to fraud.

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 CONSIDERING FRAUD RISK

Risk assessment procedures include assessing the risk of

material misstatement due to fraud or error.

The auditor’s consideration of fraud risk is made at both the

• Financial statement level and
• Assertion level for classes of transactions, account balances, and
presentation and disclosures.
Because several high-profile cases of financial statement fraud
involve misstatements in revenue recognition, auditing standards
require the auditor to presume that risks of fraud exist in revenue
recognition.

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 OBJECTIVE 9-4
Describe the auditor’s responsibility
to identify significant risks.

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 IDENTIFICATION OF SIGNIFICANT RISKS

Auditor must determine whether any of the risks identified are a

significant risk.
A significant risk is any risk that the auditor deems to require
special attention.
• Nonroutine transactions, including related-party transactions,
often represent significant risk.
• Account balances or transactions that require estimates for
which significant measurement uncertainty exists also may
require more attention.
All fraud risks are normally considered to be significant risks.

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 OBJECTIVE 9-5
Describe the audit risk model and
its components.

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 AUDIT RISK MODEL
The risk of material misstatement at the assertion level consists of
two components: inherent risk and control risk.
Auditors consider these risks by applying the audit risk model:

The relationship between the audit risk model and the understanding of the
client’s business and industry is shown in Figure 9-2.
An illustration of risks and evidence is shown in Table 9-1.

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 AUDIT RISK MODEL (CONT.)
Planned Detection Risk: The risk that the audit evidence for an audit objective will
fail to detect misstatements exceeding performance materiality.
• Planned detection risk is dependent on the other three factors in the model and will
change only if the auditor changes one of the other factors.

Inherent Risk: The auditor’s assessment of the susceptibility of an assertion to

material misstatement.

Control Risk: The auditor’s assessment of the risk that a material misstatement could
occur in an assertion and not be prevented or detected by the client’s internal controls.

Acceptable Audit Risk: How willing the auditor is to accept that the financial
statements may be materially misstated after the audit is complete and an unmodified
opinion has been issued.

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 OBJECTIVE 9-6
Assess acceptable audit risk.

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 ASSESSING ACCEPTABLE AUDIT RISK

Auditors must decide appropriate acceptable audit risk.

Auditors must first decide engagement risk and use it to modify

acceptable audit risk.
Engagement risk is the risk that the auditor (or firm) will suffer
harm after the audit is finished, even though the report was
correct.
Engagement risk is closely related to client business risk because
the risk that the auditor will be sued is often related to business
failure after the audit is finished.

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 ASSESSING ACCEPTABLE AUDIT RISK (CONT.)
Factors Affecting Acceptable Audit Risk:
• The degree to which external users rely on the statements based on these
factors:
• Client size
• Distribution of ownership
• Nature and amount of liabilities
• The likelihood that a client will have financial difficulties after the audit based on
these factors:
• Liquidity position
• Profits (losses) in previous years
• Method of financing growth
• Nature of the client’s operations
• Competence of management
• The auditor’s evaluation of management’s integrity

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 ASSESSING ACCEPTABLE AUDIT RISK (CONT.)
Making the Acceptable Audit Risk Decision

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 OBJECTIVE 9-7
Consider the impact of several
factors on the assessment of
inherent risk.

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 ASSESSING INHERENT RISK

Assessing inherent risk is an attempt by the auditor to predict

where misstatements are most and least likely in the financial
statement segments.
This affects the amount of audit evidence that the auditor needs
to accumulate.
The auditor must assess the factors that make up the risk and
modify procedures for audit evidence to take them into
consideration.
This consideration takes place during the planning phase and is
updated throughout the audit process.

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 ASSESSING INHERENT RISK (CONT.)

Factors to Consider when Assessing Inherent Risk:

• Nature of the client’s business
• Results of previous audits
• Initial versus repeat engagement
• Related parties
• Complex or nonroutine transactions
• Judgment required to correctly record account balances and transactions
• Makeup of the population
• Factors related to fraudulent financial reporting
• Factors related to misappropriation of assets

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 OBJECTIVE 9-8
Discuss the relationship of risk to
audit evidence.

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 RELATIONSHIP OF RISKS TO EVIDENCE AND
FACTORS INFLUENCING RISKS

Figure 9-3 summarizes the relationship of risk factors and

audit evidence.
In addition to modifying audit evidence, the auditor can also
make the following changes to respond to risks:
1. The engagement may require more experienced staff.
2. The engagement will be reviewed more carefully than usual.

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 RELATIONSHIP OF RISKS TO EVIDENCE AND
FACTORS INFLUENCING RISKS (CONT.)

Audit Risk for Segments—The risk of material misstatement, control risk, and
inherent risk are assessed for each audit objective in each segment of the audit.

Relating Performance Materiality and Risks to Balance-Related Audit

Objectives—Although it is common to assess inherent and control risks for each
balance-related audit objective, it is not common to allocate materiality to those
objectives.

Measurement Limitations—One major limitation in the application of the

audit risk model is the difficulty of measuring the components of the model. It is a
highly subjective process, so most auditors use broad categories such as low,
medium, and high. This is illustrated in Table 9-3.

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 RELATIONSHIP OF RISKS TO EVIDENCE AND
FACTORS INFLUENCING RISKS (CONT.)

Tests of Details of Balances Evidence-Planning Worksheet

—Auditors develop various types of decision aids to help link
judgments affecting audit evidence with appropriate evidence to
accumulate.
• One such worksheet is illustrated in Figure 9-4.

Revising Risks and Evidence—The audit risk model is primarily

a planning model and is of limited use in evaluating results.
• If audit evidence suggests that the risk is higher than originally
thought, the auditor must revise the original assessment and
consider the effect of the revision on evidence requirements.

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 OBJECTIVE 9-9
Discuss how materiality and risk
are related and integrated into the
audit process.

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 RELATIONSHIP OF RISK AND MATERIALITY
TO AUDIT EVIDENCE

The concepts of materiality and risk in auditing are

closely related and inseparable.
Risk is a measure of uncertainty.
Materiality is a measure of magnitude.
The relationships among performance materiality and
the four risks to planned audit evidence are shown in
Figure 9-5.

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