Auditing - Ch. 03 Risk Assessment And Materiality

Front 1

AUDIT RISK

Back 1

The risk (likelihood) that the auditor may unknowingly FAIL TO MODIFY THE OPINION (e.g., give an unqualified opinion on misstated financial statements).

Hint 1

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audit risk

Front 2

ENGAGEMENT RISK

Back 2

The risk that the auditor is exposed to FINANCIAL LOSS or REPUTATION DAMAGE from litigation, adverse publicity, or other events arising in connection with financial statements audited and reported on.

Hint 2

3
engagement risk

Front 3

AUDIT RISK MODEL

Back 3

Decomposes overall audit risk into 3 components:
1. INHERENT RISK (IR)
2. CONTROL RISK (CR)
3. DETECTION RISK (DR)

AR = IR x CR x DR

Hint 3

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ARM

Front 4

RISK OF MATERIAL MISSTATEMENT (RMM)

Back 4

IR x CR

Hint 4

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RMM

Front 5

WHAT STEPS ARE USED IN THE AUDIT RISK MODEL?

Back 5

1. Set a planned level of audit risk so that an opinion can be issued on the financial statements.
2. Assess inherent risk and control risk.
3. Use the audit risk equation to solve for the appropriate level of detection risk.

AR = IR x CR x DR

DR = AR / IR x CR

Hint 5

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ARM model

Front 6

WHAT ARE THE CONCEPTS OF THE ARM (the Audit Risk Model itself)?

Back 6

- The ARM formula is judgmental/theoretical/ conceptual
- Focus on the relationships the model implies (not on interpreting the numbers)
- The model is generally applied to individual accounts/balances/assertions/disclosures

Hint 6

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ARM

Front 7

WHAT ARE THE CONCEPTS OF THE ARM IN REGARDS TO THE AUDITOR?

Back 7

- Auditor cannot affect inherent risk or control risk. Auditor can only ASSESS them.
- Auditor can only affect detection risk - generally by examining more evidence or better evidence.
- For a given level of Audit Risk, Detection risk is inversely related to Control Risk and Inherent Risk.

Hint 7

3
ARM

Front 8

WHAT IS INHERENT RISK?

Back 8

The likelihood that, IN THE ABSENCE OF INTERNAL CONTROLS, a material misstatement could occur. In other words, it is a measure of the SUSCEPTIBILITY OF AN ACCOUNT TO MISSTATEMENT.

Hint 8

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inherent risk

Front 9

WHAT ARE THE FACTORS AFFECTING AN ACCOUNT'S INHERENT RISK?

Back 9

1. Dollar size of the account
2. Liquidity
3. Volume of transactions
4. Complexity of the transactions (New accounting pronouncements)
5. Subjective estimates

Hint 9

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Inherent risk

Front 10

WHAT ARE THE OTHER FACTORS AFFECTING OVERALL INHERENT RISK?

Back 10

1. Competition
2. Economy
3. Nature of Industry - cyclical vs steady
4. Management Style - aggressiveness (tone at the top)
5. Leverage - debt burden, loan convenants

Hint 10

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Inherent risk

Front 11

WHAT IS CONTROL RISK?

Back 11

The likelihood that a material misstatement would not be caught by the client's internal controls.

Hint 11

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control risk

Front 12

WHAT ARE THE FACTORS AFFECTING CONTROL RISK?

Back 12

- Control environment
- Existence (or lack thereof) and Effectiveness of control procedures
- Monitoring activities (audit committee, internal audit function, etc)

Hint 12

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control risk

Front 13

WHAT IS DETECTION RISK?

Back 13

The risk that a material misstatement would NOT BE CAUGHT BY AUDIT PROCEDURES.

Hint 13

3
detection risk

Front 14

WHAT ARE THE FACTORS AFFECTING DETECTION RISK?

Back 14

- Nature, timing, and extent of audit procedures
- Sampling risk (risk of choosing an unrepresentative sample)
- Nonsampling risk (risk that the auditor may reach inappropriate conclusions based upon available evidence, i.e., auditor error)

Hint 14

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detection risk

Front 15

WHICH FACTORS CREATE A LOWER DETECTION RISK AND WHAT IS THE EXTENT OF THE AUDIT PROCEDURES?

Back 15

Nature - More effective tests
Timing - Testing performed at year-end
Extent - More tests

Hint 15

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detection risk

Front 16

WHAT CREATES A HIGHER DETECTION RISK AND WHAT IS THE EXTENT OF THE AUDIT PROCEDURES?

Back 16

Nature - Less effective tests
Timing - Testing can be performed at Interim
Extent - Fewer tests

Hint 16

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detection risk

Front 17

WHAT ARE ERRORS (in the Risk of Material Misstatement)?

Back 17

UNINTENTIONAL MISSTATEMENTS or omissions of amounts or disclosures in financial statements.

Hint 17

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RMM

Front 18

WHAT IS MANAGEMENT FRAUD (in the Risk of Material Misstatement)?

Back 18

Includes INTENTIONAL MISSTATEMENTS or omissions of amounts or disclosures in financial statements.

Hint 18

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RMM

Front 19

WHAT IS DIRECT-EFFECT ILLEGAL ACTS (IN THE RISK OF MATERAIL MISSTATEMENT)?

Back 19

VIOLATIONS of laws or government regulations by the company or its management or employees that produce DIRECT AND MATERIAL EFFECTS on the FINANCIAL STATEMENTS (e.g., violations of tax law)

Hint 19

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RMM

Front 20

WHAT ARE SOME FAR-REMOVED (OR INDIRECT-EFFECT) ILLEGAL ACTS THAT ARE VIOLATIONS OF LAWS AND REGULATIONS THAT DO NOT DIRECTLY AFFECT THE FINANCIAL STATEMENTS?

Back 20

1. Insider securities trading
2. Occupational health and safety (OSHA) violations
3. Food and drug adminstration (FDA) violations
4. Environmental protection (EPA) violations
5. Equal employment opportunity (EEO) violations

Hint 20

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RMM

Front 21

What is the FRAUD triangle?

Back 21

When the 3 factors of Incentive/Motive, Opportunity and Rationalization are involved, there is a higher risk of fraud.

Hint 21

CH 3 - FRAUD

Front 22

What are the factors leading to an increased probability of fraud?
(Fraud Elements)

Back 22

1. INCENTIVE / MOTIVE
2. OPPORTUNITY
3. RATIONALIZATION

Hint 22

CH 3 - FRAUD

Front 23

What are the components of Risk of Material Misstatement?

Back 23

1. ERRORS
2. Management FRAUD
3. Direct-effect ILLEGAL ACTS
4. Indirect-effect ILLEGAL ACTS

Hint 23

CH 3 - FRAUD

Front 24

What does Errors mean in RMM?

Back 24

These are UNINTENTIONAL MISSTATEMENTS OR OMISSIONS of amounts or disclosures in financial statements.

Hint 24

CH 3 - FRAUD

Front 25

What does Management FRAUD mean in RMM?

Back 25

This includes INTENTIONAL MISSTATEMENTS OR OMISSIONS of amounts or disclosures in financial statements

Hint 25

CH 3 - FRAUD

Front 26

What does DIRECT-EFFECT ILLEGAL ACTS mean in RMM?

Back 26

1. Direct-effect ILLEGAL ACTS are violations of laws or government regulations by the company or its management or employees that produce DIRECT and MATERIAL effects on the financial statements (e.g., violations of tax laws)

Hint 26

CH 3 - FRAUD

Front 27

What are the Auditors' responsibilities for the detection of FRAUD

Back 27

1. Discussion among audit team members about the risks of material misstatement due to fraud.
2. Inquire of management and others about their views on the risks of fraud and how it is addressed.
3. Consider any unusual or unexpected relationships that have been found in using analytical procedures in planning the audit.
4. Understand the client's period-end closing process and investigate unexpected period-end adjustments.

Hint 27

CH 3 - FRAUD

Front 28

What is the difference between Errors and Fraud?

Back 28

Whether the misstatement was INTENTIONAL (Fraud) OR UNINTENTIONAL. (Error)

Hint 28

CH 3 - FRAUD

Front 29

What is the responsibility of the engagement team members in communication in RMM?

Back 29

Whether it is an error or fraud, the engagement should be conducted as if there is a possibility that fraud could be present.

Hint 29

CH 3 - FRAUD

Front 30

What is the responsibility of the auditor in regards to the entity's management?

Back 30

1. Auditor should find out what management knows about any fraud within the entity.
2. Auditor must understand programs and controls that management has established to prevent any risk factors and how mngmt monitors those.
3. Auditor should question the audit committee about its oversight activities in risk assessment.
4. Auditor should take inquiries and ask questions of others from within the entity (vendors, customers)

Hint 30

CH 3 - FRAUD

Front 31

What is the auditor's responsibility in regards to Direct-Effect Illegal acts?

Back 31

SAS 54 says that direct-effect illegal acts require the same assurance as frauds and errors. Even if you have no knowledge of the Direct illegal act, the auditor is responsible.

Hint 31

CH 3 - ILLEGAL ACTS

Front 32

What is the auditor's responsibility in regards to Indirect-effect Illegal acts?

Back 32

SAS 54 says that the auditor should be aware of the possibility that such illegal acts may have occurred, but if there is no knowledge of the illegal act, the auditor is not responsible.

Hint 32

CH 3 - ILLEGAL ACTS

Front 33

What does INDIRECT-EFFECT ILLEGAL ACTS mean in RMM?

Back 33

2. Indirect-effect ("FAR REMOVED") ILLEGAL ACTS are violations of laws and regulations that do not directly affect the financial statements.(e.g., OSHA violations)

Hint 33

CH 3 - ILLEGAL ACTS

Front 34

What are Direct-Effect Illegal Acts?

Back 34

Violations of laws or government regulations by the company or its management or employees that produce direct and material effects on the financial statements (e.g., violations of tax laws)
<Part of RMM>

Hint 34

CH. 3 - ILLEGAL ACTS

Front 35

What are Indirect-Effect Illegal Acts?

Back 35

These "far removed" illegal acts are violations of laws and regulations that do not directly affect the financial statements (e.g., OSHA violations, FDA violations, EPA violations)

Hint 35

CH. 3 - ILLEGAL ACTS

Front 36

What is Incentive/Motive in committing fraud ?

Back 36

One of the Fraud Elements - this is a kind of pressure that a person experiences and believes unshareable with friends and confidants encouraging the person to commit fraud.

Hint 36

CH. 3 - FRAUD ELEMENTS

Front 37

What are the Motive types?

Back 37

1. ECONOMIC: Actual of perceived need for money
2. EGOCENTRIC: Committing fraud for personal prestige
3. PSYCHOTIC: "Habitual criminal" who steals for the sake of stealing
4. IDEOLOGICAL: Cause is morally superior, justified in making others victims.
(Economic and Egocentric are the most common)

Hint 37

CH. 3 - FRAUD ELEMENTS

Front 38

What is Opportunity in committing fraud?

Back 38

One of the Fraud elements - an open door for solving the unshareable problem by violating a trust.

Hint 38

CH. 3 - FRAUD ELEMENTS

Front 39

What factors increase Opportunity in committing fraud?

Back 39

1. WEAK INTERNAL CONTROLS: (e.g., inventory not counted on a regular basis, petty cash box left unattended)
2. CIRCUMVENTION OF INTERNAL CONTROLS
3. The greater the position, the greater the trust and exposure to unprotected assets.

Hint 39

CH. 3 - FRAUD ELEMENTS

Front 40

What is Rationalization in committing fraud (misappropriation of assets)?

Back 40

When people do things that are contrary to their personal beliefs - outside their normal behavior - they provide AN ARGUMENT to make the action seem like it is IN LINE WITH THEIR MORAL AND ETHICAL BELIEFS.

Hint 40

CH. 3 - FRAUD ELEMENTS

Front 41

What are some of the red flags in employees' behavior in possible fraud?

Back 41

1. Not enough sleep
2. Drinking too much
3. Work late or work alone
4. Being irritable, defensive, argumentative

Hint 41

CH. 3 - FRAUD ELEMENTS

Front 42

What are some of the red flags in accounting records in possible fraud?

Back 42

1. Missing documents
2. Photocopied documents
3. Altered documents
4. Customer complaints
5. Inventory shortages
6. Cash shortages and overages

Hint 42

CH. 3 - FRAUD ELEMENTS

Front 43

What are some of the approaches in Fraud Prevention?

Back 43

1. Managing people pressures in the workplace (counseling, hotlines)
2. Control procedures and employee monitoring (job descriptions, willingness to enforce/prosecute)
3. Integrity by example and enforcement (ethics, code of conduct, background checks)

Hint 43

CH. 3 - FRAUD PREVENTION

Front 44

What are the required steps in the consideration of fraud in a F/S audit?

Back 44

1. Audit team discussion (brainstorming)
2. Identify information to assess fraud risk factors
3. Identify and Assess fraud risk factors
4. Respond to risk assessment
5. Evaluate audit evidence
6. Communicate fraud matters
7. Document fraud matters

Hint 44

CH. 3 - SAS 99 = STEPS IN CONSIDERATION OF FRAUD

Front 45

What is important about the audit team discussion?

Back 45

- REQUIRED ANNUAL PROCEDURE
- OBJECTIVE is to gain understanding of previous experiences with client, how a fraud might be perpetuated and covered up in the entity, and what procedures that might detect fraud.
- Discussion should be ONGOING throughout the engagement.

Hint 45

CH. 3 - SAS 99 = STEPS IN CONSIDERATION OF FRAUD

Front 46

What are the sources of information in identifying fraud risks?

Back 46

1. Inquiries of Management, Audit committees, and Internal Auditors)
2. Review of Company discussion boards
3. Planning analytical procedures (THIS IS REQUIRED) (e.g., Net income to cash flows, days sales in receivables, Gross margin, Sales growth index)

Hint 46

CH. 3 - SAS 99 = STEPS IN IDENTIFYING FRAUD RISK

Front 47

What are the categories of risk factors in fraudulent financial reporting?

Back 47

1. Management's characteristics and influence
2. Industry conditions
3. Operating characteristics and financial stability

Hint 47

CH. 3 - SAS 99 = STEPS IN IDENTIFYING FRAUD RISK

Front 48

What are the risk factors that might be caused from management's characteristics and influence?

Back 48

1. Management's pressure on employees to overstate or understate company results.
2. Management's decisions dominated by one person or a small group
3. Single focus on earnings and earnings projections.
4. High turnover of senior management.
5. History of violations
6. Evasive responses to auditors.
7. Disputes with auditors.

Hint 48

CH. 3 - SAS 99

Front 49

What risk factors might be caused by Industry conditions?

Back 49

1. Profits lag in the industry
2. New requirements potentially impair stability or profitability
3. Saturated market/fierce competition
4. Declining industry
5. Rapidly changing industry

Hint 49

CH. 3 - SAS 99

Front 50

What risk factors might be caused by Operating characteristics?

Back 50

1. Weak internal control environment
2. Cash flow problems / Pressure to raise capital
3. Complex accounting measurement and presentation issues
4. Significant related-party transactions
5. Inexperienced accounting personnel

Hint 50

CH. 3 - SAS 99

Front 51

What is involved in Step 3 of assessing fraud risks?

Back 51

1. Type of risk
2. Significance of risk
3. Liklihood of risk
4. Pervasiveness of risk
5. Controls and programs in place to prevent and detect fraud

Hint 51

CH. 3 - SAS 99

Front 52

** What are the required risk assessments?

Back 52

1. Audit team must presume that IMPROPER REVENUE RECOGNITION is a fraud risk.
2. Identify risks of MANAGMENT OVERRIDE OF CONTROLS. (Examine journal entries, Review accounting estimates, Evaluate business rationale for unusual transactions)

Hint 52

CH. 3 - SAS 99

Front 53

What are the responses to assessed risks?

Back 53

1. Change in assignment of personnel to the audit team
2. Change in extent, focus and nature of audit procedure
3. Change in predictability of auditing procedures
4. Examine journal entries
5. Review of prior year acct estimates
6. Surprise inventory counts
7. Count the petty cash twice in 1 day
8. Contract confirmations

Hint 53

CH. 3 - SAS 99

Front 54

To whom do you communicate evidence of fraud existence?

Back 54

1. Appropriate level of MANAGEMENT
-- If MATERIAL: Audit committe
-- If IMMATERIAL: to one level above
(any fraud committed by management is MATERIAL!!)

Hint 54

CH. 3 - SAS 99

Front 55

What is documented in regards to Fraud Matters?

Back 55

1. Discussion of fraud consideration by engagement team.
2. Procedures to identify and assess risk.
3. Specific risks identified and auditor responses
4. Results on procedures regarding management override.
5. Anything else that leads to more audit work
6. Communication to management and audit committee

Hint 55

CH. 3 - SAS 99

Front 56

What are the auditors' responsibilities in Direct-effect illegal acts?

Back 56

Require the same ASSURANCE AS FRAUDS AND ERRORS

Hint 56

CH. 3 - ILLEGAL ACTS

Front 57

What are the auditors' responsibilities in Indirect-effect illegal acts?

Back 57

Do not carry the same responsibility for detection and reporting as direct-effect, but the auditor should have a general awareness that these types of acts can have an effect on the F/S (esp related to contingent liabilities)

Hint 57

CH. 3 - ILLEGAL ACTS

Front 58

What are some red flags of potential Illegal acts?

Back 58

1. Unauthorized transactions
2. Government investigations
3. Regulatory reports of violations
4. Payments to consultants
5. Excessive sales commissions

Hint 58

CH. 3 - ILLEGAL ACTS

Front 59

What are the auditor's Risk Assessment procedures?

Back 59

1. Inquiries of Managements and Others
2. Analytical Procedures
3. Observation and Inspection

Hint 59

CH. 3 - SAS 99

Front 60

What MIGHT the Auditor's response be to pervasive financial statement risk?

Back 60

1. Emphasize to the Audit team the need to maintain PROFESSIONAL SKEPTICISM
2. Assign more EXPERIENCED STAFF or those with specialized skills
3. Provide more SUPERVISION
4. Incorporate additional elements of unpredicatability in the selection of audit procedures.

Hint 60

CH. 3 - AUDIT RISK

Front 61

What is MATERIALITY?

Back 61

The magnitude of an omission or misstatement of accounting information that makes it probable that the judgment of a reasonable person relying on the information would be changed or influenced by the omission or misstatement. (Emphasis is on USER, rather than management or audit team)
- MATERIALITY IS A MATTER OF PROFESSIONAL JUDGMENT.

Hint 61

CH. 3 - MATERIALITY

Front 62

What are the Qualitative criteria in Materiality?

Back 62

- Nature of the item or issue
- Circumstances
- Uncertainty

Hint 62

CH. 3 - MATERIALITY

Front 63

What are the Quantitative criteria in Materiality?

Back 63

- Absolute size
- Relative size
- Cumulative effects

Hint 63

CH. 3 - MATERIALITY

Front 64

What are the steps in applying Materiality of an Audit?

Back 64

1. Determine a materiality level for the overall financial statements (planning materiality) -- Quantitative base = 3 to 5 % of Total revenues, Gross profit, Income before taxes, Total assets, etc.
May be adjusted lower for qualitative factors.
2. Determine a tolerable misstatement (allocation of materiality at individual account/class of transactions level)
3. Evaluate auditing findings (near the end of the audit)

Hint 64

CH. 3 - MATERIALITY

Front 65

What is tolerable misstatement?

Back 65

- The amount of planning materiality allocated to an account or class of transactions.
- Combined tolerable misstatement is generally greater than planning materiality because:
---- Not all accounts will be misstated by their full tolerable misstatement allocation
---- Audits of individual accounts are conducted at the same time
---- When errors are identified, more testing is performed in that account and related accounts
---- Overall materiality serves as a "safety net"

Hint 65

CH. 3 - MATERIALITY