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Assessing risk of material misstatement• AUS 406/ASA 330 ISA 330 points out that when considering assessment of risk of material misstatement at assertion level, an auditor must relate t

Chapter 7

Assessing Specific Business Risks and

Materiality

Assessing risk of material misstatement

• AUS 406/ASA 330 (ISA 330) points out that when

considering assessment of risk of material misstatement

at assertion level, an auditor must relate these back to account balances/classes of transactions/disclosures

• Needs to consider both the particular characteristics of each class of transaction, account balance or

disclosure (inherent risks) and whether the auditor’s

assessment takes account of the entity’s controls

(control risk)

Inherent Risk (IR)

• Inherent risk:

to material misstatement, given inherent and

environmental characteristics, without regard to internal control structure.

• An assessment of IR and Control Risk (CR) can be

combined or separate Irrespective of this, an auditor is required to:

of transactions level when developing audit program.

Learning Objective 1:

Business Risk (BR) and IR

• Entity’s business strategy and associated risks will

affect an auditor’s assessment of IR at the financial

Factors affecting IR at financial report

level

• Integrity of management;

• Management experience, knowledge and changes

during the period;

• Unusual pressure on management;

• Nature of entity’s business; and

• Factors affecting the industry

Inherent risk and computer Information

Technology (IT)

• As IT risks can be pervasive to the entity, factors

affecting overall IR associated with IT are:

Inherent risk assessment at assertion level

• IR is greater for some assertions and related classes of transactions than for others

• Auditors will normally focus on:

particularly at or near year-end; and

Effect of inherent risk on account balance

assertion

Special Areas of Audit Risk:

FRAUD

• At the planning stage, an auditor should consider the risk that misstatements from fraud or error will not be detected

• It is easier to miss material misstatements resulting

from fraud because fraud involves acts designed to

conceal it

Learning Objective 2:

Audit procedures for fraud at planning

stage

• An auditor will use their experience, knowledge and

training to determine whether fraud could occur

• An auditor needs a thorough understanding of a client’s business in order to identify opportunities for the

perpetration of fraud

Increased attention to fraud

• Since June 2004, auditors have been required to pay greater attention to fraud

• Auditors need to specifically consider risks of material misstatement in financial report due to fraud;

• Auditors must discuss an entity’s susceptibility to fraud with other members of the audit team; and

• Auditors must make more extensive inquiries of

management with respect to fraud

• Auditors are now specifically required to consider the risk of fraud in revenue recognition, and the possibility

of management override of controls

Red flag indicators of fraud

• An auditor commonly uses a checklist to identify

increased risks of fraud Where risk is high, it is called a

Earnings management

• Earnings management occurs when judgment in

financial reporting and in structuring transactions is

used to alter financial reports to influence the

Broad categories of earnings management

• Earnings management by clients may fall into the

following categories

• Intentional violations of accounting standards and other reporting requirements that are individually immaterial;

• Inappropriate revenue recognition;

• ‘Big bath’ charges under the guise of restructuring; and

• Improper accruals and estimation of liabilities in good times

Considering illegal acts

• AUS 218/ASA 250 (ISA 250) provides guidance on an auditor’s consideration of illegal acts (noncompliance with laws and regulations):

framework applicable to the entity and industry;

designed to detect illegal acts; and

special attention (e.g debenture deed requires a specific current ratio be maintained) and consider these in

preparation of audit programs.

Related Parties

• An auditor must identify all related parties when

planning the audit because:

transactions can affect the financial information E.g

accounting standards require disclosure of information relating to related parties.

of that evidence Therefore, evidence from related parties and transactions with those parties need to be more

carefully evaluated.

motivated by other than ordinary business conditions,

such as fraud.

Learning Objective 3:

Procedures for identifying related parties

• Review the previous period’s working papers for known related parties;

• make inquiries of management concerning the names

of all related parties;

• review the entity’s procedures for identifying related

parties;

• inquire about management’s and directors’ affiliations with other entities;

• review minutes of meetings; and

• inquire of other auditors involved in the audit

Preliminary Assessment of Going Concern

Basis

• Going Concern:

and continue to operate without any intention necessarily

to liquidate or otherwise wind up operations Refer AUS 708.03/ASA 570.06 (ISA 570.03)

concern at planning stage.

appropriateness of presentation of financial report or

might motivate management misrepresentations.

Learning Objective 4:

Preliminary Assessment of Going Concern

Basis (cont.)

• Early identification helps focus audit effort on

appropriate assertions in the financial report, and

permits early communication with management

• An auditor focuses primarily on anticipated events

during the relevant period, approximately 12 months

from the date of the current audit report to the expected date of the next audit report

Examples of indications of going concern

problems

• Operating indicators include:

Examples of indications of going concern

problems (cont.)

• Financial indicators:

Examples of indications of going concern

problems (cont.)

• Other indications:

or extend existing loans.

subsidiaries or associates.

• Materiality:

separately in a financial report may adversely affect either user decisions or the discharge of accountability by

management Refer AUS 306.03/ASA 320.06 (ISA

320.03)

• Auditor uses materiality to:

procedures (sometimes called planning materiality).

Learning Objective 5:

Quantitative guidelines:

MATERIALITY

• Material   10% of appropriate base amount

• Immaterial   5% of appropriate base amount

• Judgment  5-10% of appropriate base amount

• Base amount for balance sheet items  equity, or the appropriate asset or liability class total

• Base amount for income statement items  net profit or loss and appropriate revenue and expense amount, for year or averaged over a number of years

Setting the preliminary materiality

judgment

• When planning the audit, an auditor makes a

preliminary estimate of the amount to be considered

material for audit purposes

• Conceptually encompasses:

• A single amount is normally estimated for materiality because misstatements usually affect both balance

sheet and income statement

Rules of thumb for planning materiality

Financial information used as base

• Can be taken from:

Consideration of qualitative factors in

materiality

• An auditor should consider qualitative factors as well as quantitative assessment Qualitative factors include:

misstatement might affect the presentation of numerous items in the financial report); and

whole.

Allocation of materiality to account

balances and classes of transactions

• An auditor needs to allocate planning material to

account balances and classes of transactions for audit testing (Auditing standards are silent on this issue.)

• No required or optimal method, but an auditor should consider:

• Dollar value of account

• Expectation of error

Relationship between materiality and audit

risk

• There is an inverse relationship between audit risk and materiality

• An auditor sets a lower materiality threshold for

accounts that have a higher audit risk This means the auditor will need to collect more evidence for these

accounts