Audit Risk

2. Audit Risk The possibility that the auditors may unknowingly fail to appropriately modify their opinion on financial statements that are materially misstated This is the risk that the auditors will issue an unqualified opinion on financial statements that contain a material departure from GAAP. Auditors must obtain sufficient appropriate audit evidence to reduce audit risk to a low level in every audit.

3. Financial Statement Assertions Assertions about account balances (Accounts) Assertions about classes of transactions and events (Transactions) Assertions about presentation and disclosure (Disclosures)

4. Financial Statement Assertions: Auditing Standards Board and International Standards

5. Combined Assertions Used in this Text Existence or Occurrence--Assets, liabilities, and equity interests exist and recorded transactions have occurred Rights and Obligations--The company holds rights to the assets, and liability are the obligations of the company Completeness--All assets, liabilities, equity interests, and transactions that should have been recorded have been recorded Cutoff—Transactions and events have been recorded in the correct accounting period Valuation, Allocation and Accuracy—All transactions, assets, liabilities and equity interests are included in the financial statements at proper amounts Presentation and Disclosure--Accounts are described and classified in accordance with generally accepted accounting principles, and financial statement disclosures are complete, appropriate, and clearly expressed

6. Audit Risk Risk of Material Risk That the Audit Risk = Misstatement * Auditors Fail to the Misstatement = Inherent Control Detection Risk * Risk * Risk Inherent Risk--Risk of a material misstatement occurring in an assertion assuming no related internal controls. Control Risk--Risk that a material misstatement in an assertion will not be prevented or detected on a timely basis by the company’s internal control. Detection Risk--Risk that the auditors’ procedures will lead them to conclude that a material misstatement does not exist in an assertion when in fact such misstatement does exist.

7. Audit Risk Formula AR = IR * CR * DR AR = Audit risk IR = Inherent risk CR = Control risk DR = Detection risk

8. Audit Risk Figure 5. 2

9. Inherent Risk Factors that affect inherent risk: Nature of the client and its environment Nature of the particular financial statement element Business characteristics indicative of high inherent risk: Inconsistent profitability of client Operating results highly sensitive to economic factors Going concern problems Large known and likely misstatements detected in prior audits Substantial turnover, questionable reputation, or inadequate accounting skills of management

10. Assertions with high inherent risk Involve: Difficult to audit transactions or balances Complex calculations Difficult accounting issues Significant judgment by management Valuations that vary significantly based on economic factors

11. Types of transactions Routine Recurring financial statement activities recorded in the accounting records in the normal course of business Lower inherent risk Nonroutine Involve activities that occur only periodically such as the taking of physical inventories High inherent risk Estimation transactions Activities that create accounting estimates Higher inherent risk

12. The Third Field Work Standard Third standard of field work: The auditor must obtain sufficient appropriate audit evidence by performing audit procedures to perform a reasonable basis for an opinion regarding the financial statements under audit Sufficient audit evidence The quantity of audit evidence that must be obtained

13. Appropriateness of Audit Evidence To be appropriate audit evidence must be: Relevant Reliable Principles—Audit evidence is ordinarily more reliable when it is Obtained from knowledgeable independent sources outside the company rather than nonindependent sources Generated internally through a system of effective controls rather than ineffective controls. Obtained directly by the auditor rather than indirectly or by inference Documentary in form rather than oral Provided by original documents rather than copies

14. Reliability of Certain Types of Audit Evidence • RELIABILITY TYPE EXAMPLE • High Physical Inventory Observation • Documentary • External Cutoff Bank Statement • External/Internal Purchase Invoice • Internal Sales Invoice • Low Client Representations Management Representation • Letter

15. Types of Audit Evidence

16. Overall Types of Audit Procedures Risk assessment procedures To obtain an understanding of the client and its environment, including its internal control, to assess the risks of material misstatement Further Audit Procedures Tests of controls When appropriate, to test the operating effectiveness of controls in preventing material misstatements Substantive procedures To detect material misstatements at relevant assertion level. Substantive procedures include (a) analytical procedures, (b) tests of details of account balances, transactions and disclosures

17. Substantive Procedures Analytical procedures Tests of details Tests of account balances Tests of classes of transactions Tests of disclosures One may change the scope of audit procedures by changing the (NTE, or re-ordered as NET): Nature (type and form) Timing (when performed) Extent (quantity of evidence obtained)

18. Nature and Timing of Procedures Holding the extent of procedures constant, one may increase the scope of procedures (make them more effective) by either changing the • Nature-- obtain more reliable evidence • often externally generated evidence. • Timing--wait until year-end to obtain evidence from entire set of transactions as contrasted to performing interim testing, say two months prior to year-end and simply updating those procedures.

19. Extent of Procedures Holding other factors such as the nature and timing of procedures constant: • The greater the risk of material misstatement, the greater the needed extent of substantive procedures • The main way to increase the extent of audit procedures is to examine more items • Sample sizes should reduce detection risk so as to restrict audit risk to a low level

20. Analytical Procedures (1 of 2) Steps involved Develop expectation of account (or ratio) balance Determine amount of difference that can be accepted without investigation Compare the company’s account (ratio) with the expectation Investigate and evaluate significant differences Developing an expectation Prior period information Anticipated results Relationships among elements of financial information within a period Industry information Relationships between financial information and relevant nonfinancial data.

21. Analytical Procedures (2 of 2) Types of Expectations Trend analysis—analyze changes in accounts of a company over time Ratio analysis – compare relationships between two or more financial statement accounts or comparisons of account balances to nonfinancial data Liquidity (e.g., current ratio) Leverage (e.g., debt to equity) Profitability (e.g., gross profit percentage) Activity (e.g., inventory turnover)

22. Ratio Analysis Approaches to ratio analysis Horizontal analysis Review ratios over time Cross sectional analysis Analyze ratios of similar firms at a point in time Vertical analysis Analyze relationships within a period “Common size” statements prepared Other methods Regression analysis, reasonableness test

23. Identifying Potential Misstatements

24. Basic Approaches to Auditing Accounting Estimates Review and test management’s process for developing the estimate. Independently develop an estimate to compare to management’s estimate. Review subsequent events or transactions bearing on the estimate.

25. Auditing Fair Values Inputs to use in applying valuation techniques (FAS 157) Level 1 – inputs of observable quoted prices in active markets for identical assets or liabilities Ex. A closing stock price in WSJ Level 2 – inputs of observable quoted prices, generally for similar assets or liabilities in active markets Ex. Company discounts future cash flows on its not publicly traded debt securities at rate used by market for publicly traded debt securities Level 3 – inputs that are unobservable for the assets or liability Ex. A private company uses judgment to determine a proper rate to discount the future cash flows of its not publicly traded securities

26. Related Party Transactions Disclosure requirements must be met Primary challenge is identifying undisclosed related party transactions Determine related parties Inquiries of management Review SEC filings, stockholder’s listings and conflict-of-interest statements Be alert for transactions with related parties and any transactions with unusual terms

27. Functions of Audit Documentation Primary functions: Support the auditors’ compliance with auditing standards Support the auditors’ opinion Secondary functions: Assist continuing and new audit team members in planning and performing the audit Serves as a record of matters of continuing audit interest Assists in supervision and review of the audit Demonstrates the accountability of team members Assists internal reviewers, external peer reviewers, PCAOB inspectors, and successor auditors in performing their roles

28. Sufficiency of Audit Documentation Audit documentation should be sufficient to: Enable an experienced auditor to understand the work performed and the significant conclusions reached Identify who performed and reviewed the work Show that the accounting agree or reconcile to the financial statements Audit documentation should include all significant audit findings and the actions taken to address them

29. Types of Working Papers Audit administrative working papers Working trial balance Lead schedules Adjusting journal entries and reclassification entries Supporting schedules Analysis of a ledger account Reconciliations Computational working papers Corroborating documents

30. Types of Working Files Current files Current year working papers Index and cross-referencing Permanent files Items of continuing audit interest

32. Preparation of a Working Paper – Figure 5.8