Bus 426 - Chapter 7

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Business Administration
BUS 426
Michael Favere- Marchesi

Chapter 7 -Materiality and Risk  Risk means the acceptance by auditors that there is some level of uncertainty in performing the audit function     Audit Risk Model: A formal model reflecting the relationships among audit risk (AR), inherent risk (IR), control risk (CR) and planned detection (PD)  AR = IR x CR x PDR  Mainly used to decide how much evidence to accumulate in each cycle  Audit Risk: A measure of how willing the auditor is to accept the financial statements may be materially misstated after the audit is completed and an unqualified audit opinion has been issued o Complement to Audit Assurance, an audit risk of 2% is the same as an audit assurance of 98%  Inherent Risk: A measure of the auditor’s assessment of the likelihood that there are material misstatements in a segment before considering the effectiveness of internal controls o Implies that auditors should attempt to predict where misstatements are most or least likely in the financial statement segments o Risk of Material Misstatements: The expectation of misstatements after considering the effect of internal controls on inherent risk Chapter 7 -Materiality and Risk  Control Risk: A measure of the auditor’s assessment of the likelihood that misstatements exceeding materiality in a segment will not be prevented or detected by the client’s internal controls o 100% control risk factor means no reliance on internal control and must be set at the beginning at every audit  To lower this risk, auditors must:  1. Understand the client’s controls  2. Evaluate the controls  3. Test the controls  Planned Detection Risk: A measure of the risk that audit evidence for a segment will fail to detect misstatements exceeding materiality, should such misstatements exist o PDR = AR / ( IR x CR) o Dependent on the other 3 factors of the audit (AR, IR, CR) o If PDR = 2%, then auditor needs to provide 98% assurance  “Auditor plans 2 percent risk of not detecting errors and so seeks 98 percent assurance from substantive tests”  See page 210 for relationship of these risks   Business Risks  Client Business Risk: The risk that the client will fail to achieve its objectives, leading to business failure o Auditors may or may not accept this job because it may lead to engagement risk or auditor business risk, which is the risk that audit firms will suffer after the audit is finished  The likelihood is that if the client goes bankrupt after the audit, they may sue the auditors  Factors that affect business risks: o The degree to which external users rely on the statements  Larger the client size, more widely used the statements  Distribution  Nature of liabilities, the more liabilities, the more creditors would focus on your statements o The likelihood of the client having financial difficulties after the audit report  Liquidity position of the client  Profits (losses) in previous years Chapter 7 -Materiality and Risk  Method of financing growth  Nature of the client’s operations, some industries riskier than others  Competence of management o The integrity of management  Frequent disagreements with previous auditors  Conflicts with shareholders, regulators, customers  Criminal convictions of key members of the group   Inherent Risk Assessment  The auditor should consider several major factors when assessing inherent risk:  Nature of the client’s business o For example, there is a greater likelihood of obsolete inventory in an electronics manufacturer than for a steel fabricator
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