Chapter Three

Risk Assessment
and Materiality

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 Audit Risk

The
The risk
risk that
that an
an auditor
auditor expresses
expresses
an
an inappropriate
inappropriate audit
audit opinion
opinion when
when
the
the financial
financial statements
statements are
are
materially
materially misstated.
misstated.

Individual account
Financial statement
balance or class
level
of transactions level

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 Auditor’s Business Risk

Client and third

party lawsuits

An auditor’s exposure
to financial loss and
damage to
professional reputation.

Negative
publicity
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 The Audit Risk Model

Risk that material misstatements exist

Audit Risk = RMM× DR

Detection risk:
Risk that auditor will not detect misstatements

• Inappropriate audit procedure

• Fail to detect when using Non-sampling Sampling
appropriate audit procedure
risk risk
• Misinterpreting audit results

McGraw-Hill/Irwin
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 The Audit Risk Model
Inherent risk and control risk:
Risk that material misstatements exist

Audit Risk = IR × CR × DR

Detection risk:
Risk that auditor will not detect misstatements

• Inappropriate audit procedure

• Fail to detect when using Non-sampling Sampling
appropriate audit procedure
• Misinterpreting audit results risk risk

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 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 bebe issued
issued onon the
the financial
financial statements.
statements.
 Assess
 Assess risk
risk of
of material
material misstatements.
misstatements.
 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 = MRR × DR
AR
DR = MRR
Auditors use this level of detection risk to design audit
procedures that will reduce audit risk to an acceptable level.

McGraw-Hill/Irwin
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 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 bebe issued
issued on
on the
the financial
financial statements.
statements.
 Assess
 Assess inherent
inherent risk
risk and
and control
control risk.
risk.
 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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 Using the Audit Risk Model

McGraw-Hill/Irwin
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 Using the Audit Risk Model

Qualitative
Qualitative terms
terms may
may also
also be
be used
used in
in the
the audit
audit risk model..
risk model

Case
Case AR
AR RMM
RMM DR
DR
11 Very
Verylow
low High
High Low
Low
22 Low
Low Moderate
Moderate Moderate
Moderate
33 Very
Verylow
low Low
Low High
High

McGraw-Hill/Irwin
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 Using the Audit Risk Model

Qualitative
Qualitative terms
terms may
may also
also be
be used
used in
in the
the audit
audit risk model..
risk model

Case
Case AR
AR IR
IR CR
CR DR
DR
11 Very
Verylow
low High
High High
High Low
Low
22 Low
Low Low
Low High
High Moderate
Moderate
33 Very
Verylow
low Low
Low Low
Low High
High

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 Limitations of the Audit Risk Model
The
Theaudit
auditrisk
riskmodel
modelisisaaplanning
planningtool,
tool,but
butitithas
hassome
some
limitations
limitationsthat
thatmust
mustbe
beconsidered
consideredwhen
whenthethemodel
modelisis
used
usedto torevise
revisean
anaudit
auditplan
planor
orto
toevaluate
evaluateaudit
auditresults.
results.

•• The
The desired
desiredlevel
levelof
ofaudit
auditrisk
riskmay
maynot
notactually
actually
be
beachieved.
achieved.
•• ItItdoes
doesnot
notconsider
considerpotential
potentialauditor
auditorerror.
error.
•• There
Thereisisno
nowaywayof
ofknowing
knowingwhatwhatthe
thepreliminary
preliminary
level
levelof
ofriskriskactually
actuallywas.
was.

Preliminary Actual
Assessment +/– or Achieved
Level of Risk Level of Risk

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 The Auditor’s Risk
Assessment Process
Auditors need to
identify business risks and
understand the potential
misstatements that
may result.
Business risks
include any external or
internal factors, pressures, and
forces that bear on the entity’s
ability to survive and
be profitable.

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 The Auditor’s Risk Assessment Process

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 Understanding the Entity
and Its Environment
Regulatory Nature of
Industry Environment the Entity
Factors

Business
Objectives and Risks
Accounting Strategies
policies

Financial Internal
Performance Control
Measures

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 Understanding the Entity
and Its Environment

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 Understanding the Entity
and Its Environment

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 Auditor’s Risk Assessment Procedures
(How do we gather this evidence?)

Inquiries of
Management
and Others

Analytical Observation
Procedures and Inspection

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 Assessing the Risk of Material
Misstatement Due to Error or Fraud
AA misstatement
misstatement due due toto error
error or
or fraud
fraud
is
is aa difference
difference between
between the the amount,
amount,
classification,
classification, or or presentation
presentation of of aa
reported
reported financial
financial statement
statement element,
element,
account,
account, or or item
item and
and the
the amount,
amount,
classification,
classification, or or presentation
presentation
that
that would
would havehave
been
been reported
reported under
under thethe applicable
applicable
financial
financial reporting
reporting framework.
framework.

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 Assessing the Risk of Material
Misstatement Due to Error or Fraud
Examples
Examples of
of misstatements
misstatements include:
include:

 An
Aninaccuracy
inaccuracyin ingathering
gatheringor orprocessing
processingdata datafrom
from
which
whichthe
thefinancial
financialstatements
statementsare areprepared.
prepared.

 An
Anomission
omissionof of an
anamount
amount or ordisclosure.
disclosure.

 An
Anincorrect
incorrect accounting
accountingestimate
estimatearising
arisingfrom
from
overlooking
overlookingororclear
clearmisinterpretation
misinterpretationof of facts.
facts.

 Management’s
Management’sselection
selectionand andapplication
applicationof of
accounting
accountingpolicies
policiesthat
that the
theauditor
auditorconsiders
considers
inappropriate
inappropriateororjudgements
judgementsconcerning
concerning
accounting
accountingestimates
estimatesthatthat the
theauditor
auditorconsiders
considers
unreasonable,
unreasonable, including
includingrelated disclosures..
relateddisclosures

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 Assessing the Risk of Material
Misstatement Due to Error or Fraud
Errors
Errors are
are unintentional
unintentional misstatements:
misstatements:
 Mistakes
Mistakesin
ingathering
gatheringor
orprocessing
processingfinancial
financial
data
dataused
usedtotoprepare
preparefinancial
financialstatements.
statements.
 Unreasonable
Unreasonableaccounting
accountingestimates
estimatesarising
arising
from
fromoversight
oversight or
ormisinterpretation
misinterpretationof of facts.
facts.
 Mistakes
Mistakesin inthe
theapplication
applicationofof accounting
accounting
policies
policiesrelating
relatingto
toamount,
amount, classification,
classification,
manner
mannerof of presentation,
presentation, or
ordisclosure.
disclosure.

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 Assessing the Risk of Material
Misstatement Due to Error or Fraud

Fraud
Fraudinvolves
involves
intentional
intentional misstatements.
misstatements.

Fraudulent
Fraudulent Misappropriation
Misappropriation
financial
financialreporting
reporting of
of assets
assets

McGraw-Hill/Irwin
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 Assessing the Risk of Material
Misstatement Due to Error or Fraud
Fraudulent
Fraudulent financial
financial reporting
reporting includes
includes acts
acts
such
such as
as the
the following:
following:
 Manipulation,
Manipulation, falsification,
falsification, or
oralteration
alterationof
of
accounting
accountingrecords
recordsor orsupporting
supportingdocuments
documents
used
usedto toprepare
preparefinancial
financialstatements.
statements.
 Misrepresentation
Misrepresentationin, in, or
orintentional
intentionalomission
omission
from,
from, the
thefinancial
financialstatements
statementsof of events,
events,
transactions,
transactions, ororsignificant
significant information.
information.
 Intentional
Intentionalmisapplication
misapplicationof of accounting
accountingpolicies
policies
relating
relatingto
toamount,
amount, classification,
classification, manner
mannerofof
presentation,
presentation, orordisclosure.
disclosure.

McGraw-Hill/Irwin
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 Assessing the Risk of Material
Misstatement Due to Error or Fraud
Misappropriation
Misappropriation of of assets
assets involves
involves the
the theft
theft
of
of an
an entity’s
entity’s assets
assets to
to the
the extent
extent that
that
financial
financial statements
statements are
are misstated.
misstated.
Examples
Examples include:
include:

Embezzling
cash received
Stealing
assets Paying for
goods and services
not received

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 Assessing the Risk of Material
Misstatement Due to Error or Fraud
Categorisation
Categorisationininevaluating
evaluatingmisstatements
misstatements
identified
identifiedduring
duringthe
theaudit
audit(ISA
(ISA450):
450):
•• Factual
Factualmisstatements
misstatementsare aremisstatements
misstatementsaboutaboutwhich
which
there
thereisisno
nodoubt.
doubt.
•• Judgemental
Judgementalmisstatements
misstatementsare aredifferences
differencesarising
arisingfrom
from
the
theselection
selectionor orapplication
applicationof ofaccounting
accountingpolicies
policiesthat
thatthe
the
auditor
auditorconsiders
considersinappropriate,
inappropriate,or orthe
thejudgements
judgementsof of
management
managementconcerning
concerningaccounting
accountingestimates
estimatesthat
thatthe
the
auditor
auditorconsiders
considersunreasonable.
unreasonable.
•• Projected
Projectedmisstatements
misstatementsare arethe
theauditor’s
auditor’sbest
bestestimate
estimate
of
ofmisstatements
misstatementsininpopulations,
populations,involving
involvingthe
theprojection
projectionof of
misstatements
misstatementsidentified
identifiedininaudit
auditsamples
samplesto tothe
theentire
entire
populations
populationsfrom
fromwhich
whichthethesamples
sampleswere
weredrawn.
drawn.

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 The Fraud Risk
Identification Process
Discussion
Discussion Inquiries
Inquiries of
of
among
among thethe management
management
audit
audit team
team and
and others
others

Sources of
Fraud
Fraud information
risk
risk factors
factors
Analytical
Analytical
procedures
procedures
Other
Other relevant
relevant
information
information
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 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 Opportunity
Opportunity Attitude
Attitudeor or
pressure
pressuretoto to
tocarry
carryout
out rationalisation
rationalisation
perpetrate
perpetratefraud
fraud the
thefraud
fraud to
tojustify
justifyfraud
fraud

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 Assessing the Risk of Material Misstatement
Due to Error or Fraud (See Table 3-4)
Fraudulent Financial Reporting
Risk Factors Relating to Incentive/Pressure
include:
Financial
Financial stability
stability
or
or profitability
profitability
is
is threatened
threatened

Excessive
Excessive pressure
pressure Management’s
Management’s personal
personal
for
for management
management to to financial
financial situation
situation
meet
meet third
third party
party is
is threatened
threatened
expectations
expectations

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 Assessing the Risk of Material Misstatement
Due to Error or Fraud (See Table 3-5)
Fraudulent Financial Reporting
Risk Factors Relating to Opportunities
include:
Nature
Nature Complex
Complex
of
of the
the or
or unstable
unstable
industry
industry organisational
organisational
structure
structure
Ineffective
Ineffective
monitoring
monitoring ofof Deficient
Deficient
management
management internal
internal
control
control

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 Risk Factors Relating to
Attitudes /Rationalisations (See
Table 3-6)
Fraudulent Financial Reporting
Risk Factors Relating to
Attitudes/Rationalisations include:
Use
Use ofof Poor
Poor communication
communication
inappropriate
inappropriate accounting
accounting channels
channels for
for reporting
reporting
based
based on
on materiality
materiality inappropriate
inappropriate behaviour
behaviour
Committing
Committing to to
aggressive
aggressive or or
unrealistic
unrealistic forecasts
forecasts Weak
Weak ethical
ethical
standards
standards for
for
management
management
behaviour
behaviour
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 Assessing the Risk of Material
Misstatement Due to Error or Fraud
Misappropriation of Assets
Risk Factors for Misappropriation of Assets
include:

Access Adverse Personal

to assets employee management financial
relationships pressures
Lack of
inventory No mandatory Small, valuable
control vacation policy inventory items
Inadequate
separation Employee
of duties Sudden changes in disregard
employee behaviour of internal
control
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 Auditor’s Response to the Risk
Assessment

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 Auditor’s Response to the Risk Assessment

Significant risks require special audit

considerations

Fraud risk Non-routine or Significant

factors unsystematically accounting
processed transactions estimates

Significant
Highly Industry
Revenue transactions
complex specific issues
recognition with related
transactions
parties
Application of Significant
new accounting transactions outside the
standards normal course of
McGraw-Hill/Irwin
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 Evaluation of Audit Test Results
At
At the
the completion
completion of
of the
the audit,
audit, the
the auditor
auditor should
should consider:
consider:

1.
1. The
The effect
effect of
of the
the identified
identified misstatements
misstatements on
on the
the audit.
audit.
2.
2. Whether
Whether the
the uncorrected
uncorrected misstatements
misstatements cause
cause the
the financial
financial
statements
statements to to be
be materially
materially misstated.
misstated.

McGraw-Hill/Irwin
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 Evaluation of Audit Test Results
IfIf the
the auditor
auditor determines
determines that
that the
the misstatement
misstatement isis or
or
may
may be be the
the result
result of
of fraud,
fraud, and
and has
has determined
determined that
that
the
the effect
effect could
could be
be material,
material, the
the auditor
auditor should:
should:
 Attempt
Attempt to to obtain
obtain audit
audit evidence
evidence to to determine
determine whether,
whether, in in
fact,
fact, material
material fraud
fraud has
has occurred
occurred and,
and, ifif so,
so, its
its effect.
effect.
 Consider
Consider the the implications
implications for
for other
other aspects
aspects of of the
the audit.
audit.
 Discuss
Discuss the the matter
matter andand the
the approach
approach to to further
further
investigation
investigation withwith anan appropriate
appropriate level
level of
of management
management
that
that is
is at
at least
least one
one level
level above
above those
those involved
involved in in
committing
committing the the fraud
fraud and
and with
with senior
senior management.
management.
 IfIf appropriate,
appropriate, suggest
suggest that
that the
the client
client consult
consult withwith legal
legal
counsel.
counsel.
 Consider
Consider withdrawing
withdrawing from
from the
the engagement.
engagement.

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 Documentation of the Auditor’s Risk
Assessment and Response
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 toto fraud
fraud
and
and aa description
description of of the
the auditor’s
auditor’s 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 ofof the
the communications
communications about about fraud
fraud made
made to to
management,
management, those those charged
charged withwith governance,
governance, and and
others.
others.
 The
 The basis
basis for
for the
the auditor’s
auditor’s conclusions
conclusions about
about the the
reasonableness
reasonableness of of accounting
accounting estimates
estimates that
that give
give rise
rise to
to
significant
significant risks.
risks.
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 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 bebe brought
brought to
to the
the attention
attention
of
of an
an appropriate
appropriate level
level ofof 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 bebe
reported
reported directly
directly toto those
those charged
charged with
with governance.
governance.

The
The auditor
auditor should
should reach
reach an
an understanding
understanding with
with those
those
charged
charged with
with governance
governance regarding
regarding the
the expected
expected nature
nature
and
and extent
extent of
of communications
communications about
about misappropriations
misappropriations
perpetrated
perpetrated by
by lower-level
lower-level employees.
employees.

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 Communications about Fraud
The
The disclosure
disclosure of of fraud
fraud to
to parties
parties other
other than
than the
the client’s
client’s
senior
senior management
management and and those
those charged
charged withwith
governance
governance ordinarily
ordinarily isis not
not part
part of
of the
the auditor’s
auditor’s
responsibility
responsibility and
and ordinarily
ordinarily would
would bebe precluded
precluded by by the
the
auditor’s
auditor’s ethical
ethical and
and legal
legal obligations
obligations ofof confidentiality.
confidentiality.

IFAC
IFAC Code
Code of
of Ethics
Ethics for
for Professional
Professional Accountants
Accountants
provides
provides guidance
guidance onon circumstances
circumstances where
where auditors
auditors
should
should disclose
disclose confidential
confidential information
information or
or when
when such
such
disclosure
disclosure may
may be
be appropriate.
appropriate.

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 Materiality
Misstatements,
Misstatements, including
including omissions,
omissions, areare considered
considered to to
be
be material
material ifif they,
they, individually
individually or
or in
in the
the aggregate,
aggregate,
could
could reasonably
reasonably be be expected
expected toto influence
influence the
the
economic
economic decisions
decisions of of users
users taken
taken on
on thethe basis
basis of
of the
the
financial
financial statements.
statements.
Judgements
Judgements about
about materiality
materiality are
are made
made inin light
light of
of
surrounding
surrounding circumstances,
circumstances, and and are
are affected
affected byby the
the
size
size or
or nature
nature of
of aa misstatement,
misstatement, oror aa combination
combination of of
both..
both

Materiality is not an absolute and

it is not a black or white issue!
Materiality is a matter of professional judgement.

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 Steps in Applying Materiality
on an Audit
Step
Step 1:
1:
Determine
Determine Materiality
Materiality and
and Performance
Performance Materiality
Materiality for
for the
the
Financial
Financial Statements
Statements

Step
Step 2:
2:
Determine
Determine Materiality
Materiality and
and Performance
Performance Materiality
Materiality for
for
Classes
Classes of
of Transactions,
Transactions, Account
Account Balances
Balances or
or Disclosures
Disclosures

Step
Step 3:
3:
Evaluate
Evaluate audit
audit findings
findings

McGraw-Hill/Irwin
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 Step 1 – Determine Materiality and Performance
Materiality for the Financial Statements

The
The quantitative
quantitative benchmark
benchmark At
At the
the planning
planning stage
stage the
the
for
for materiality
materiality may
may be
be aa auditor
auditor should
should also
also determine
determine
percentage
percentage of:of: performance
performance materiality.
materiality.
•• Profit
Profit before
before taxes
taxes from
from
continuing
continuing operations.
operations. Performance
Performance materiality
materiality isis set
set
•• Total at
at aa lower
lower amount
amount than
than
Total assets.
assets.
materiality
materiality toto provide
provide aa margin
margin
•• Total
Total revenues.
revenues. for
for possible
possible undetected
undetected
•• Three
Three year
year average profit..
average profit misstatements.
misstatements.

McGraw-Hill/Irwin
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 Step 2 –Determine Materiality and Performance
Materiality for Classes of Transactions, Account
Balances or Disclosures
•• Auditing
Auditing standards
standards require
require that
that the
the auditor
auditor in
in the
the specific
specific
circumstances
circumstances of of the
the entity
entity determines
determines lesser
lesser amounts
amounts
than
than materiality
materiality for
for the
the financial
financial statements
statements as
as aa whole
whole for
for
particular
particular classes
classes of of transactions,
transactions, account
account balances
balances or
or
disclosures.
disclosures.

•• For
For the
the purpose
purpose of
of establishing
establishing the
the scope
scope of of audit
audit
procedures
procedures thethe auditor
auditor may
may also
also find
find itit appropriate
appropriate to
to
determine
determine performance
performance materiality
materiality for
for classes
classes of
of
transactions,
transactions, account
account balances,
balances, or
or disclosures.
disclosures.

•• The
The specific
specific policies
policies and
and procedures
procedures of of individual
individual audit
audit
firms
firms may
may differ
differ inin allocating
allocating materiality
materiality to
to individual
individual
elements
elements of
of financial
financial statements.
statements.

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 Step 3 – Evaluate Audit Findings
When
When the
the audit
audit evidence
evidence is
is gathered,
gathered, the
the auditor:
auditor:

•• Evaluates
Evaluates ifif identified
identified misstatements
misstatements affect
affect the
the
overall
overall audit
audit strategy
strategy and
and audit
audit plan.
plan.

•• Communicates
Communicates and
and requests
requests management
management and and
those
those charged
charged with
with governance
governance to
to correct
correct identified
identified
misstatements.
misstatements.

•• Evaluates
Evaluates the
the effect
effect of
of uncorrected
uncorrected misstatements
misstatements
on
on the
the financial
financial statements.
statements.

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© The McGraw-Hill Companies 2010
 Step 3 – Evaluate Audit Findings

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 End of Chapter 3

McGraw-Hill/Irwin
© The McGraw-Hill Companies 2010