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Chapter 6

Chapter 6 - Assessing Risks and Internal Control

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ACC 521
Larry Yarmolinsky

Chapter 6 –Assessing Risks and Internal Control Audit Risk:An EssentialAudit Planning Decision The higher the assurance, the lower the audit risk. • Audit risk is the probability that an auditor will FAILTO EXPRESS a reservation of opinion on financial statements that are materially misstated.  Audit risk is greater if there is poor planning or poor execution of the audit.  Audit risk is inversely proportionate to risk of getting sued.  Audit risk is dependent on user reliance.  Audit risk is also applied to individual account balances and disclosures. • Auditors strive to lower audit risk by performing audit work that gives a high level of assurance that statements are correct. • Auditors need to assess risk in audit related terms; inherent risk, control risk and detection risk. TheAudit Risk Model Audit Risk (AR) = Inherent Risk (IR) X Control Risk (CR) X Detection Risk (DR) Audit Risk = The probability that the audit fails. Keep it less than 5%. How much risk is the audit willing to take before giving a bad opinion? Low, medium or high risk? Not doing well = audit risk is low - we are not willing to take allot of risk Business is great = high audit risk - we can take on more risk Impacts the audit risk:  likelihood of financial failure  users of the financial statement  Management integrity • Inherent Risk – The probability that material misstatements could have occurred.  Amaterial misstatement has been made in the transactions or balances.  Care should be greater when inherent risk is greater.  Examples:  First time audit = high risk vs. Repeated - low  Estimates are subjective - many estimates = higher risk  Management Bias - incentives = higher risk • Control Risk – The risk that the client’s internal controls will not prevent or detect a material misstatement.  Assessment is based on study and evaluation of the company’s control system.  Risk can never be zero because management can override it (collusion, human error etc...)  Start with anchoring (preconceived knowledge of last year’s conclusions on control risk assessment)  Can be a pitfall if conditions worsen from last year. • Detection Risk – The risk that the auditor’s procedures will fail to find a material misstatement that exists in the accounts.  Audit procedures also fail to detect the misstatement.  Auditors want this risk LOW (opposite of other two)  Test using substantive procedures: 1. Tests the details of random transactions, balances, and disclosures. 2. Analytical procedures. How are Materiality and Audit Risk Related? Materiality refers to the magnitude of a misstatement; audit risk refers to the level of assurance that material misstatement does not exist. • The auditor will make these assessments independently. • Both deal with sufficiency of evidence and extent of audit evidence that will be collected. Business Risk-BasedApproach toAuditing Requires the auditor to understand the company’s business risks/strategy and its related internal control. There are 2 parts of business risk analysis: 1. Strategic analysis 2. Business Process analysis At the end of the business risk analysis, the auditor should be able to answer: 1.
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