Audit Risk free essay sample

A. Define audit risk. Audit risk is the risk that the auditors may unknowingly fail to appropriately modify their opinion on financial statements that are materially misstated. B. Describe its components of inherent risk, control risk, and detection risk. The risk of material misstatement may be separated into two components-inherent risk and control risk. Both inherent risk and control risk exist independently of the audit of financial statements, or in other words, the risk of misstatement exists regardless of the audit being done or not. Inherent risk is the possibility of material misstatement of an assertion before considering the clients internal control. Factors that affect this are from the nature of the client and its environment, or from the nature of the account. The auditor should seriously consider whether to accept the engagement because inherent risk increases the overall risk of the audit. It is often useful to segregate transactions into three types- routine, non-routine, and estimation when assessing inherent risk. The assessment of what is material is a matter of professional judgment. In designing the audit plan, the auditor establishes an acceptable materiality level so as to detect quantitatively material misstatements. However, both the amount (quantity) and nature (quality) of misstatements need to be considered. Examples of qualitative misstatements would be the inadequate or improper description of an accounting policy when it is likely that a user of the financial statements would be misled by the description, and failure to disclose the breach of regulatory requirements when it is likely that the consequent imposition of regulatory restrictions will significantly impair operating capability. The auditor needs to consider the possibility of misstatements of relatively small amounts that, cumulatively, could have a material effect on the financial statements. For example, an error in a month end procedure could be an indication of a potential material misstatement if that error is repeated each month. The auditor considers materiality at both the overall financial statement level and in relation to individual account balances, classes of transactions, account balances, and disclosures. Materiality may be influenced by considerations such as legal and regulatory requirements and considerations relating to classes of transactions, account balances, and disclosures and their relationships 5. 6. 7. ISA 320 (CONFORMED) 2 AUDIT MATERIALITY (CONFORMED) individual financial statement account balances and relationships. This process may result in different materiality levels depending on the aspect of the financial statements being considered. 8. Materiality should be considered by the auditor when: (a) (b) Determining the nature, timing and extent of audit procedures; and Evaluating the effect of misstatements. The Relationship between Materiality and Audit Risk 9. When planning the audit, the auditor considers what would make the financial statements materially misstated. The auditor’s understanding of the entity and its environment establishes a frame of reference within which the auditor plans the audit and exercises professional judgment about assessing the risks of material misstatement of the financial statements and responding to those risks throughout the audit. It also assists the auditor to establish materiality and in evaluating whether the judgment about materiality remains appropriate as the audit progresses. The auditor’s assessment of materiality, related to specific account balances and classes of transactions, account balances, and disclosures helps the auditor decide such questions as what items to examine and whether to use sampling and substantive analytical procedures. This enables the auditor to select audit procedures that, in combination, can be expected to reduce audit risk to an acceptably low level. There is an inverse relationship between materiality and the level of audit risk, that is, the higher the materiality level, the lower the audit risk and vice versa. The auditor takes the inverse relationship between materiality and audit risk into account when determining the nature, timing and extent of audit procedures. For example, if, after planning for specific audit procedures, the auditor determines that the acceptable materiality level is lower, audit risk is increased. The auditor would compensate for this by either: (a) Reducing the assessed risk of material misstatementlevel of control risk, where this is possible, and supporting the reduced level by carrying out extended or additional tests of control; or Reducing detection risk by modifying the nature, timing and extent of planned substantive procedures. 0. (b) Materiality and Audit Risk in Evaluating Audit Evidence 11. The auditor’s assessment of materiality and audit risk may be different at the time of initially planning the engagement from at the time of evaluating the results of audit procedures. This could be because of a change in circumstances or because of a change in the auditor’s knowledge as a result of performing audit proceduresthe audit. For example, if the audit procedures are performed 3 ISA 320 (CONFORMED) AUDIT MATERIALITY (CONFORMED) is planned prior to period end, the auditor will anticipate the results of operations and the financial position. If actual results of operations and financial position are substantially different, the assessment of materiality and audit risk may also change. Additionally, the auditor may, in planning the audit work, intentionally set the acceptable materiality level at a lower level than is intended to be used to evaluate the results of the audit. This may be done to reduce the likelihood of undiscovered misstatements and to provide the auditor with a margin of safety when evaluating the effect of misstatements discovered during the audit. Evaluating the Effect of Misstatements 12. In evaluating whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework, the fair presentation of the financial statements the auditor should assess whether the aggregate of uncorrected misstatements that have been identified during the audit is material. The aggregate of uncorrected misstatements comprises: (a) Specific misstatements identified by the auditor including the net effect of uncorrected misstatements identified during the audit of previous periods; and The auditor’s best estimate of other misstatements which cannot be specifically identified (i. e. , projected errors). 13. (b) 14. The auditor needs to consider whether the aggregate of uncorrected misstatements is material. If the auditor concludes that the misstatements may be material, the auditor needs to consider reducing audit risk by extending audit procedures or requesting management to adjust the financial statements. In any event, management may want to adjust the financial statements for the misstatements identified. If management refuses to adjust the financial statements and the results of extended audit procedures do not enable the auditor to conclude that the aggregate of uncorrected misstatements is not material, the auditor should consider the appropriate modification to the auditor’s report in accordance with ISA 700, â€Å"The Auditor’s Report on Financial Statements. If the aggregate of the uncorrected misstatements that the auditor has identified approaches the materiality level, the auditor would consider whether it is likely that undetected misstatements, when taken with aggregate uncorrected misstatements could exceed materiality level. Thus, as aggregate uncorrected misstatements approach the materiality level the auditor would consider reducing audit the risk by performing additional audit procedures or by 15. 16. ISA 320 (CONFORMED) 4 AUDIT MATERIALITY (CONFORMED) equesting management to adjust the financial statements for identified misstatements. Public Sector Perspective 1. In assessing materiality, the public sector auditor must, in addition to exercising professional judgment, consider any legislation or regulation which may impact that assessment. In the public sector, materiality is also based on the â€Å"context and nature† of an item and includes, for example, sensitivity as well as value. Sensitivity covers a variety of matters such as compliance with authorities, legislative concern or public interest. 5 ISA 320 (CONFORMED)