Chapter 6: Risk assessment

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18 Terms

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Audit risk

inherent risk x control risk x detection risk

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Inherent risk

entity risk

Susceptibility of an assertion about a class of transaction, account balance, or disclosure to a misstatement that could be material either individually or when aggregated with other misstatements, before consideration of any related internal controls

… is affected by the nature of the entity (industry, regulation…).

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Control risk

entity risk
the risk that a material misstatement that could occur in an assertion about a class of transaction, account balance or disclosure and that could be material, individually or when aggregated with other misstatements, will not be prevented or detected and corrected on a timely basis by the entity's internal control.

eg: human error.

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Detection risk

Auditor risk

The risk that the procedures performed by the auditor to reduce audit risk to an acceptably low level will not detect a misstatement that exists and that could be material, either individually or when aggregated with other misstatements

- Two components:

  • sampling risk (sample is not appropriate for the population as a whole)

  • non-sampling risk (not detect material misstatement due to factors other than the sample tested: eg time pressure, experience, financial constraint, poor planning....)

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risk-based approach

  • Analyse the risk in the client's business, transactions and systems that could lead to material misstatement in the financial statements

  • Direct audit testing to risky area

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materiality

Information is material if its omission or misstatement could reasonably be expected to influence the economic decisions of users taken on the basis of the financial statements.

two aspects of materiality:

  • Quantitative materiality

  • Qualitative materiality

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Performance materiality

the amount or amounts set by the auditor at less than materiality for the financial statements as a whole to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements exceeds materiality for the financial statements as a whole".

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ISA 315 distinguishes two main types of risk

  • Risks at the financial statement level are pervasive to the financial statements and may affect any assertion - for example, the effects of a poor management attitude to internal control could be felt in any area of the financial statements.

  • Risks at the assertion level are more specific and will take the form of specific issues - for example, a company which keeps inventory in multiple locations will be subject to the inherent risk that not all inventory will be counted, and may also be subject to a control risk in relation to the entity's system for counting that inventory.

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Significant risk

For which the assessment of inherent risk is close to the upper end of the spectrum of inherent risk due to the degree to which inherent risk factors affect the combination of the likelihood of a misstatement occurring and the magnitude of the potential misstatement should that misstatement occur; or

•That is to be treated as a significant risk in accordance with the requirements of other ISAs.

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Risk factor

  • Complexity

  • Subjectivity

  • Change

  • Uncertainty

  • Management bias or fraud risk

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  • Complexity

  • Regulatory - lots of complex regulation

  • Business model - complex alliances and joint ventures

  • Financial reporting framework - complex accounting measurements

  • Transactions - complex arrangements (eg off-balance sheet finance)

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Subjectivity

Financial reporting framework:

• Wide range of possible accounting estimates (eg depreciation)

• Management choice of valuation technique

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Change

Changes in:

  • Economic conditions - instability (eg current devaluation) Markets - exposure ot volatility (eg futures trading)

  • Customer loss - going concern / liquidity risk

  • Industry model - changes ni the industry ni which hte entity operates

  • Business model - change ni supply chain, new lines of business Geography -expanding into new locations

  • Entity structure - for example reorganisations, subsidiaries solo TI -TI environment change / new TI systems relevant to FR

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Uncertainty

Financial reporting - estimation uncertainty Pending litigation and contingent liabilities

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Management bias or fraud risk

Opportunities for fraudulent financial reporting Transactions with related parties

Non-routine or non-systemic transactions

Transactions recorded based on management intentions

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fraud

  • Fraudulent financial reporting (intentional misstatements, including omissions of amounts or disclosures in financial statements, to deceive financial statement users)

  • Misappropriation of assets (the theft of an entity's assets)

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Benchmarks:

- 0.5 to 1% revenue

- 1to 2% total assets

- 5 to 10% PBT

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