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What is Audit Risk?
The risk that an auditor expresses an inappropriate audit opinion when the financial statements are materially misstated
Can audit risk ever be zero?
No!
What are the 3 stages of audit risk minimization?
Identification of accounts and related assertions most at risk of material misstatement (inherent risk)
Assessment of client’s system of internal controls (control risk)
Auditor plans to undertake detailed testing of each identified account to the extent deemed necessary
What are some factors that make risks more significant?
Fraud
Transactions where subjectivity is involved
Accounting estimates with high estimation uncertainty or complexity
Complexity in data collection and/or processing
Mergers and acquisitions
Audit Risk Formula: AR =
AR = Inherent Risk x Control Risk x Detection Risk
What is Inherent Risk?
Risk that material misstatement could occur
What is Control Risk?
Risk that the client’s system of internal controls will not prevent or detect such a material misstatement
What is Detection Risk?
Risk that the auditor’s testing procedures will not be effective in detecting a material misstatement, should there be one
Describe the Audit Risk Model
Errors are reduced through each stage (top to bottom)
What are the two common relationship patterns between IR, CR, and DR?
If IR and CR are high, DR is low → more testing
If IR and CR are low, DR is high → less testing
Define Materiality
Materiality guides audit planning, testing, and assessment of information in the financial statements
What make information “material?”
Information is material if it impacts on the decision-making process of users of the financial statements
Information could be considered material because of its qualitative or quantitative characteristics
What is performance materiality?
an amount less than planning materiality, to reduce the likelihood that a misstatement in a particular account balance, class of transactions, or disclosures does not in total exceed overall materiality
What are 3 things we know about an audit strategy?
It sets scope, timing, and direction of the audit
It provides basis for developing detailed audit plan
It is based on preliminary assessments of IR and CR
When CR is high, what kind of audit strategy is commonly used?
A predominantly substantive approach (less testing of controls)
When CR is low and DR is high, what kind of audit strategy is most commonly used?
A combined audit strategy (extensive testing of controls + detailed understanding of internal controls)
What are two common client performance measures?
Profitability and Liquidity
What is an analytical procedure?
Evaluation of financial information by studying plausible links among both financial and non-financial data
How can an analytical procedure be conducted?
Risk assessment
Risk response
Reporting
What are some common examples of analytical procedures?
Simple comparisons
Trend analysis
Common-size analysis (vertical analysis)
Ratio analysis
