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Lecture 3

AFM202 Lecture Notes - Lecture 3: Measurement Uncertainty, Internal Control, Audit Risk
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3 Pages
27 Views
Fall 2018

Department
Accounting & Financial Management
Course Code
AFM202
Professor
Alan Mc Naughton
Lecture
3

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Audit Risk
Audit risk - the probability than an auditor will fail to express a modified opinion (reservation) that
financial statements are materially misstated
o Measure of the audit's willingness to accept that the financial statements may be materially
misstated event though a proper audit has been conducted
o 2% to 5%
Depends on who are the users of the financial statements
The more users and the less sophisticated, the lower the risk
Auditor chooses this number
Complete assurance is impossible to achieve
The lower the acceptable audit risk, the greater the certainty the auditor wants to achieve and the
greater the amount of audit evidence and costs
Audit Risk Model
AR = RMM (Risk of Material Misstatement = inherent risk x control risk) x DR
RMM - risk of errors in the financial statements
o High, moderate or low
o Not controlled by the auditor
A material misstatement has been made in the transactions or balances
o Inherent risk
Internal controls fail to detect or correct the misstatement
o Control risk
Audit procedures fail to detect the misstatement
o Detection risk
Fail that all the audit work failed to detect errors
Auditors usually like to limit the audit risk to less than 5%
AR is set by auditor at acceptable level before audit planning is done
Auditor assesses RMM but has no control over these risks
Auditor designs audit procedures to reduce DR to a level that results in AR which is below the
acceptable level
Conditions and Events That May Indicate RMM
Operation subject to a high degree of complex regulations
Incentives to engage in fraudulent financial reporting
o Competition
o IPO
o On the road to bankruptcy
New business lines
Expanding to new locations
Acquisitions, reorganizations, other unusual events
Significant related party transactions
o Research on the client
o Past transactions
Lack of personnel with appropriate accounting skills
Turnover of key executives
Deficiencies in internal control
o Prevent and detect errors
Changes in IT environment

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Description
Audit Risk Audit risk - the probability than an auditor will fail to express a modified opinion (reservation) that financial statements are materially misstated o Measure of the audit's willingness to accept that the financial statements may be materially misstated event though a proper audit has been conducted o 2% to 5% Depends on who are the users of the financial statements The more users and the less sophisticated, the lower the risk Auditor chooses this number Complete assurance is impossible to achieve The lower the acceptable audit risk, the greater the certainty the auditor wants to achieve and the greater the amount of audit evidence and costs Audit Risk Model AR = RMM (Risk of Material Misstatement = inherent risk x control risk) x DR RMM - risk of errors in the financial statements o High, moderate or low o Not controlled by the auditor A material misstatement has been made in the transactions or balances o Inherent risk Internal controls fail to detect or correct the misstatement o Control risk Audit procedures fail to detect the misstatement o Detection risk Fail that all the audit work failed to detect errors Auditors usually like to limit the audit risk to less than 5% AR is set by auditor at acceptable level before audit planning is done Auditor assesses RMM but has no control over these risks Auditor designs audit procedures to reduce DR to a level that results in AR which is below the acceptable level Conditions and Events That May Indicate RMM Operation subject to a high degree of complex regulations Incentives to engage in fraudulent financial reporting o Competition o IPO o On the road to bankruptcy New business lines Expanding to new locations Acquisitions, reorganizations, other unusual events Significant related party transactions o Research on the client o Past transactions Lack of personnel with appropriate accounting skills Turnover of key executives Deficiencies in internal control o Prevent and detect errors Changes in IT environment
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