audit risk and materiality

auditing

audit risk

the risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated, the financial statements are not presented fairly in conformity with the applicable financial reporting framework.

audit risk formula

inherent risk x control risk x detection risk

inherent risk

possibility of material misstatement of a financial statement assertion before considering any related controls

control risk

the risk that an error will not prevented or detected/corrected by clients internal controls

detection risk

risk that an error in the unaudited financial statements will not be detected

characteristics that increase inherent rosk

Operating results that are highly sensitive to economic factors.

Going concern problems.

Large misstatements detected in prior audits.

Substantial turnover, questionable reputation, or inadequate accounting skills of management.

assertions with high inherent risk

Inconsistent profitability of the client relative to other firms in the industry.

Difficult-to-audit transactions or balances.

Complex calculations.

Difficult accounting issues.

Significant judgment by management.

Valuations that vary significantly based on economic factors

transaction types

routine

nonroutine

estimation

routine transaction

involve recurring financial statement activities recorded in the accounting records in the normal course of business

nonroutine transactions

involve activities that occur only periodically, such as
- Taking physical inventories
- Calculating depreciation expense
- Adjusting financial statements for foreign currency gains and losses

estimation trnascation

the activities that create accounting estimates and generally the transactions with the highest level of inherent risk. activities have high inherent risk because they involve management judgments or assumptions.

control risk

is the risk that a material misstatement could occur in a financial statement assertion and not be prevented, or detected and corrected, on a timely basis by internal control.

It is a function of the effectiveness of both the design and operation of internal control in achieving the client’s objectives relevant to the preparation of its financial statements

the risk of material misstatement

inherent risk x contorl risk

detection risk

the risk that the procedures performed by the auditor will not detect a misstatement [in the unaudited financial statements] that exists and that could be material, individually or in combination with other misstatements

Detection risk is affected by

the effectiveness of the substantive procedures

their application by the auditor, i.e., whether the procedures were performed with due professional care.

the better/stronger the procedures…

the lower the detection risk

substantive audit procedures

Tests of details of balances, transactions, and disclosures

Substantive analytical procedures

Reasonable assurance is obtained by

reducing audit risk to an appropriately low level through applying due professional care, including obtaining sufficient appropriate audit evidence, i.e., they have an adequate quantity (sufficient) of relevant and reliable (appropriate) audit evidence.

materiality

a matter of professional judgment about whether misstatements, individually or aggregated, would influence the judgment made by a reasonable user based on the financial statements.

materiality threshods

Materiality for financial statements as a whole
Based on a percentage of a benchmark
Performance materiality (AU-C 320.09)
An amount less than planning materiality

purpose of material thresholds

Used to make sure that the aggregate of uncorrected and undetected immaterial misstatements does not exceed overall materiality

qualitative factors

Item is measured precisely (vs. imprecise estimates)

Item masks a change earnings or other trends

Hides failure to meet analysts’ consensus expectations

Item changes loss into income or vice versa

Item concerns significant segment of business

Item affects regulatory compliance

Item affects compliance with loan covenants (or other agreements)

Item increases management compensation

Item conceals an unlawful transaction

concept of audit risk and materiality

interrelated and must be considered together by the auditor.

if materiality increases…

inherent and control risk decreases

audit risk

(1) the risk of material misstatement of a relevant assertion related to an account balance, class of transaction, or disclosure
(2) the risk that the auditors will not detect such misstatement.

5 financial assertions

existence or occurence

completeness

valuation and allocation

rights and obligations

presentation dn disclosure