Bus 426 - Lecture 3.docx

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Simon Fraser University
Business Administration
BUS 426
Michael Favere- Marchesi

Lecture 3 What is risk?  Uncertainty  Audit Risk: The risk when the auditor’s opinion comes out but there is really a misstatement in the financial statements o Audit Risk = 1 – Assurance, ex: In our opinion, we are 95% confident that the financial statements are fairly stated o Audit Risk is a strategic approach to accounting, views the audit as a tactical plan of action  Tactical Phase = Performance of Audit Tests  Audit Procedures are designed to satisfy audit objectives in order to reduce the probability of misstatement  Also a risk when the auditor states that the statements are unfairly statement  damage reputation  Auditors can’t test for everything, so they do take an amount of risk  Usually for large firms, audit risk is lower (in comparison to small firms), this is because more users use the financial statements for large firms Components of an Audit Risk 1. Inherent Risk: Unavoidable risks 2. Control Risk: Internal Controls, catches some misstatements 3. Detection Risk: Auditor Controls, catches more misstatements Audit Risk = IR x CR x DR  Multiplicative means they are independent of each other  AR, IR, CR are all assessment inputs, and DR is the output, influences the extent of testing  So rewritten as: DR = AR / (IR x CR) o If AR goes UP, so does the DR and vise-versa  Means you are willing to take more risk, so you would collect less evidence  To memorize, just use the rewritten formula Audit Detection Inherent Control Risk Evidence Risk Risk Risk Up Up Down Down Down Up Down Up Up Up Down Down How to Assess Audit Risk  Nature of Users: If only the CEO uses the statements, then we can take a bigger risk; in comparison to public companies where many users depend on this, we take a lower risk  Likelihood of Financial Difficulties  Management Integrity: Is management very aggressive in accounting? Do they cross the line? Honest or not management? Matter of trusting who you are dealing with  Business Risk: Is the business industry dangerous? Inherent Risk  The likelihood of misstatements due to the nature of the segment o IE: The account of inventory vs plant, property and equipment… Which is more risky? Inventory  How to determine which account is more inherently risky?  Nature of Business  Nature of Information System (IT System): Do they have a program that does the accounting for them, or do they have a manual accounting system?  Integrity of Management  Client Motivation: What is the client’s objective of this audit?  Initial vs Repeat Engagement  Results of Prior Audits  Related Parties: A company with a lot more related party transactions are inherently more risky (because they are not at arms length)  Non-Routine Transactions: Usually found in journal entries near the year-end  Judgments Required to Record Account Balances and Transactions Correctly  Assets Susceptible to Misappropriation: Assets which may be stolen  Makeup of the Population: Who are the client’s customers Control Risk  The likelihood that misstatements will not be prevented or detected by internal control system  Required by GAAS to evaluate the internal control system even if you will not place reliance on the internal controls  Needed in order to design the nature and extent of the audit test  Mix of Test of Controls + Test of Details to evaluate this system  To rely on the internal control system:  Obtain an understanding of the internal controls system  Evaluate design effectiveness based on the understanding o Identify the strengths and weaknesses of the internal control system  Test the internal control
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