Chapter 4

Risk Assessment

McGraw-Hill/Irwin

Copyright 2012 by The McGraw-Hill Companies, Inc. All

LO# 1

Audit Risk
The
The risk
risk that
that an
an auditor
auditor expresses
expresses
an
an unqualified
unqualified opinion
opinion on
on materially
materially
misstated
misstated financial
financial statements.
statements.

Financial statement
level

Individual account
balance or class
of transactions level
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LO# 2

The Audit Risk Model

Inherent risk and control risk:
Risk of material misstatement

Audit Risk = IR CR DR
Detection risk:
Risk that auditor will not detect misstatements

Inappropriate audit procedure

Fail to detect when using
appropriate audit procedure
Misinterpreting audit results

Nonsampling
risk

Sampling
risk
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LO# 2

Engagement Risk
Client and third
party lawsuits

An auditors exposure
to financial loss and
damage to
professional reputation.

Local audit
failure

Negative
publicity
4-4

LO# 3

Using the Audit Risk Model

Set
Set aa planned
planned level
level of
of audit
audit risk
risk such
such that
that an
an opinion
opinion
can
can be
be issued
issued on
on the
the financial
financial statements.
statements.

Assess
Assess the
the risk
risk of
of material
material misstatement
misstatement (IR
(IR xx CR).
CR).

Use
Use the
the audit
audit risk
risk equation
equation to
to solve
solve for
for the
the appropriate
appropriate
level
level of
of detection
detection risk:
risk:

AR = IR CR DR

AR
DR =
IR CR
Auditors use this level of detection risk to design audit
procedures that will reduce audit risk to an acceptable level.
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Limitations of the
Audit Risk Model

LO# 3

The
Theaudit
auditrisk
riskmodel
modelisisaaplanning
planningtool,
tool,but
butitithas
hassome
somelimitations
limitations
that
thatmust
mustbe
beconsidered
consideredwhen
whenthe
themodel
modelisisused
usedto
torevise
revisean
anaudit
audit
plan
planor
orto
toevaluate
evaluateaudit
auditresults.
results.

The
The desired
desiredlevel
levelof
ofaudit
auditrisk
riskmay
maynot
notactually
actuallybe
beachieved.
achieved.
ItItdoes
doesnot
notconsider
considerpotential
potentialauditor
auditorerror.
error.
There
Thereisisno
noway
wayof
ofknowing
knowingwhat
whatthe
thepreliminary
preliminarylevel
levelof
ofrisk
risk
actually
actuallywas.
was.

Preliminary
Assessment
Level of Risk

+/

Actual
or Achieved
Level of Risk
4-6

LO# 4

The Auditors Risk Assessment Process

Figure 4-2 An Overview of the Auditors Assessment of Business Risks and the Risk of
Material Misstatements

4-7

LO# 5

Assessing the Risk of Material

Misstatement Due to Error or Fraud
Errors
Errors are
are unintentional
unintentional misstatements
misstatements::

Mistakes
Mistakes in
in gathering
gathering or
or processing
processing financial
financial data
data used
used
to
to prepare
prepare financial
financial statements.
statements.
Unreasonable
Unreasonable accounting
accounting estimates
estimates arising
arising from
from
oversight
oversight or
or misinterpretation
misinterpretation of
of facts.
facts.
Mistakes
Mistakes in
in the
the application
application of
of accounting
accounting principles
principles
relating
relating to
to amount,
amount, classification,
classification, manner
manner of
of
presentation,
presentation, or
or disclosure.
disclosure.

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LO# 6

Assessing the Risk of Material

Misstatement Due to Error or Fraud
Fraud
Fraud involves
involves intentional
intentional
misstatements
misstatements.. The
The fraud
fraud risk
risk
identification
identification process
process includes:
includes:

Sources
Sources of
of information
information about
about possible
possible
fraud
fraud

Communications among the audit team

Communications among the audit team
Inquires of management and others
Inquires of management and others
Analytical procedures
Analytical procedures

Unexpected period-end adjustments

Unexpected period-end adjustments

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LO# 6

Assessing the Risk of Material Misstatement

Due to Error or Fraud
(Fraud Triangle)
Three
Threeconditions
conditionsusually
usually
exist
existwhen
whenfraud
fraudoccurs.
occurs.

Incentive
Incentiveor
or
pressure
pressureto
to
perpetrate
perpetratefraud
fraud

Opportunity
Opportunity
to
tocarry
carryout
out
the
thefraud
fraud

Attitude
Attitudeor
or
rationalization
rationalization
to
to justify
justifyfraud
fraud

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Auditors Response to
the Risk Assessment (See Figure 4-3)

LO# 7

Assess the risk of material misstatement at the financial statement and assertion levels.
Financial statement level risks

Do these
risks relate
pervasively to
the financial
statements?

No

Assertion level risks

Determine what can go wrong

at the account or assertion level.

Yes

Develop an overall
response.

Design audit
procedures for
assertion level risks.

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Evaluation of Audit
Test Results

LO# 8

At
At the
the completion
completion of
of the
the audit,
audit, the
the auditor
auditor should
should consider:
consider:
1.
1. Whether
Whether the
the accumulated
accumulated results
results of
of audit
audit procedures
procedures affect
affect the
the
assessments
assessments of
of the
the entitys
entitys business
business risk
risk and
and the
the risk
risk of
of material
material
misstatement,
misstatement, and
and
2.
2. Whether
Whether the
the total
total misstatements
misstatements cause
cause the
the financial
financial statements
statements to
to be
be
materially
materially misstated.
misstated.

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Documentation of the
Auditors Risk Assessment

LO# 9

The
The auditor
auditor should
should document:
document:

Discussions
Discussions among
among engagement
engagement personnel.
personnel.

Procedures
Procedures performed
performed to
to identify
identify and
and assess
assess the
the risks
risks
of
of material
material misstatement
misstatement due
due to
to fraud.
fraud.

Risks
Risks of
of identified
identified material
material misstatement
misstatement due
due to
to fraud
fraud
and
and aa description
description of
of the
the auditors
auditors response
response to
to the
the risks.
risks.

Fraud
Fraud risks
risks or
or other
other conditions
conditions that
that result
result in
in additional
additional
audit
audit procedures.
procedures.

The
The nature
nature of
of the
the communications
communications about
about fraud
fraud made
made to
to
management,
management, the
the audit
audit committee,
committee, and
and others.
others.
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LO# 10

Communications about Fraud

Whenever
Whenever the
the auditor
auditor has
has found
found evidence
evidence that
that aa fraud
fraud may
may exist,
exist,
that
that matter
matter should
should be
be brought
brought to
to the
the attention
attention of
of an
an appropriate
appropriate
level
level of
of management.
management. Fraud
Fraud involving
involving senior
senior management
management and
and
fraud
fraud that
that causes
causes aa material
material misstatement
misstatement of
of the
the financial
financial
statement
statement should
should be
be reported
reported directly
directly to
to the
the audit
audit committee
committee of
of the
the
board
board of
of directors.
directors.

The
The auditor
auditor should
should reach
reach an
an understanding
understanding with
with the
the audit
audit
committee
committee regarding
regarding the
the expected
expected nature
nature and
and extent
extent of
of
communications
communications about
about misappropriations
misappropriations perpetrated
perpetrated by
by lowerlowerlevel
level employees.
employees.
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End of Chapter 4

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