Chapter 4

Audit Risk
Risk that an auditor expresses an inappropriate audit opinion
when the financial statements are materially misstated.
Auditor will aim to recue audit risk to an acceptably low level.
Can be reduced at the planning stage of the audit by identifying
the key risks faced by the client and allocating more audit time
to gathering sufficient and appropriate evidence where the risk
of material misstatement is the highest.
Inherent Risk
The susceptibility of f/s to a material misstatement without
considering internal controls
Considering nature of the business, the industry, any previous
experience with the client.
Assertion
Statement made by management regarding the recognition,
measurement, presentation, and disclosure of items included in
the financial statements and notes.
Help guide the testing conducted by an auditor
Significant Risk
An identified and assessed risk of material misstatement that
requires special audit consideration.
Examples
o Fraud
o Related to significant economic or accounting
developments
o Involves complex transactions
o Involves significant subjectivity in measurement of
financial information
o Involves significant transactions outside the clients normal
course of business.
Control Risk
Risk that a clients system of internal controls will not prevent or
detect a material misstatement.
Stages in Audit Minimization
1. Assessing the risk of material misstatements involving inherent
risk

2. Evaluation of the clients system of internal controls, assessing

their control risk.
3. Auditor will plan to undertake detailed tested of each identified
account to the extent that is necessary.
The risk of material misstatement exists at the financial statement
level and at the assertion level
Financial statement risk of material misstatement refers to risk
that affect the financial statements as a whole
Assertion risk of material misstatement refers to risks that
affect classes of transactions, account balances, and disclosures.
o Comprises of inherent risk and control risk
Inherent Risk possibility that material misstatement
could occur before consideration of internal controls
Example) competitive environment, current
economic environment, the risk of
technological obsolescence, and the level of
government regulation
Control Risk risk that a clients system of internal
controls will not prevent or detect a material
misstatement
Consider the organizations attitudes toward
controls and the control procedures
implemented
o Inherent and control risk are the clients risks
o Auditor will determine the detection risk in response to the
assessed audit risk and the clients inherent and control
risk combined.
Detection Risk the risk that auditors testing procedures will not
be effective in detecting a material misstatement.
Audit Risk =

Inherent Risk *
High
Low

Control Risks *
High
Low

Detection Risk
Low
High

Acceptable audit risk for f/s overall is set by the auditor at the
beginning of audit
o Tends to be quite low 0-5% and remains constant
throughout audit
o Inverse relationship between assessed level of Inherent
and control risk (risk of material misstatement) and the
acceptable level of detection risk

o When detection risk is low, the auditor will increase the

level of reliance placed on their detailed substantive
procedures.
o When detection risk is high, this means the auditor will
reduce the level of reliance placed on their detailed
substantive procedures.
o Read over the Livent case on Page 135
Materiality
Information that impacts the decision-making process of users of
the f/s
Includes information that is misstated or omitted but should be
disclosed
Qualitative
o Significant due to change in accounting method, related
party transactions, change in operations that affects level
of fraud faced, and the danger of breaching a debt
covenant.
o Compliance with the law
o All disclosure in f/s and notes must clearly reflect auditors
understanding of the company
Quantitative
o Information that exceeds an auditors preliminary
materiality assessment
o Auditor will select an appropriate base and then decide on
percentage to use depending on the clients circumstances
Example ) public company uses net income before
tax as base on non-profit organization uses
assets/expenses as base
o Any item that is 10%> is considered to be material, any
item <5% of profit before tax is immaterial
Performance Materiality
An amount less than materiality, which is set by the auditor to reduce
the likelihood that any uncorrected and undetected misstatements
within a class of transactions, account balances, or disclosures, in
aggregate, do not exceed overall materiality (use professional
judgement)
Specific Materiality
Information that is relevant when some areas of the f/s are expected to
influence the economic decisions made by users of the f/s (example,
maintaining a current ratio)
Materiality and Audit

If materiality were assessed in terms of audit risk, a higher risk

audit would have a lower materiality than a low risk audit of a
similar entity.
Smaller misstatements will be identified and additional audit
work performed on higher risk engagement to reduce audit risk
to an acceptably low level.

Audit Strategy
Strategy that sets the scope, timing, and direction of the audit
and provides the basis for developing a detailed audit plan.
Substantive audit strategy
o Does not plan to rely on clients controls and increases the
reliance on detailed substantive procedures that involve
intensive testing of year end account balances and
transactions from throughout the year
o Exception: when an auditor has identified a significant risk,
the auditor will gain an understanding of clients controls
relevant to the risk.
Combined Audit Strategy
o Strategy used when the auditor obtains a detailed
understanding of their clients system of internal controls
and plans to reply on that system to identify, prevent, and
detect material misstatements
o Cannot completely rely on a clients system of internal
controls and will always conduct some substantive
procedures to gather independent evidence regarding f/s
numbers
Client Approaches to measuring performance

Key Performance Indicators

o Used by a client to monitor and assess its own
performance and the performance of its senior staff
provide an auditor with insight into the accounts that their
client focuses on when compiling its f/s and indicate which
accounts are potentially at risk of material misstatement
Profitability
o Ability to earn profit
o Tracking revenue and expenses over time and assess any
variability
o Compare with close competitors and assess their ability to
compete
PE ratio

EPS
Inventory Turnover

Liquidity
o Ability of company to meet its needs for cash in short/long
term
Analytical Procedures
o Evaluation of financial information by studying plausible
relationships among both financial and non-financial data.
o During execution stage, analytical procedures are an
efficient method of identifying differences between
recorded amounts and the auditors expected values that
require further investigation.
Comparisons
o Between account balances for current year and previous
years
o Significant changes should be tracked and investigated
further by the auditor
Trend Analysis
o Comparison of account balances over time
o Selecting a base year and then restating all accounts in
subsequent years as a percentage of that base
Common Size analysis
o Comparison of account balances to a single line item
o Balance sheet > sales / revenue
Ratio Analysis
o Profitability ratios
Gross profit margin
Profit Margin
ROA
ROE
o Liquidity Ratios
Current Ratio
Asset test (quick) ratio
Inventory turnover
Receivables Turnover
o Solvency Ratios
Debt to equity ratio
Times interest earned
Factors to consider when conducting analytical procedures
o Reliability of client data
o Ability to make comparisons over time
o Investigate all significant unexpected fluctuations

Case 4.2 Computer Company

Looking at Inherent risk of inventory
Rapid obsolescence > valuation
Competition is aggressive In a competitive industry, it would
result in too much inventory. (Overvalue of inventory have to
sell for less for the products cost)
Quality and delay (consider foreign purchases /exchanges)
Foreign Exchange transactions
Risk of Theft
Strengths/ Weaknesses of Control System
Strengths
Weaknesses
Training of staff
Casual workers
Supervision of staff
Central Manager
Requisitions required
authorized by branch
manager
Inventory in central location
where there is specialized
staff
(All the controls are not
useful if the staff is
overriding the control)
Is inventory material for this company? Yes, probably the highest
balance on Balance sheet (maybe besides PP&E)
Company probably doesnt have A/R.
Want to know their inventory turnover. (Is there old inventory that is
unable to meet demand?)

Audit Approach
Yes- we should use different approach for different inventory controls.
For Carl, they will look at larger dollar values
Items with greatest risk of being stolen and to make sure inventory
isnt overstated.
Materiality Anna
Materiality of $70000, Nothing over $45, 000. Does this mean she can
ignore the account?
Yes there can still be materiality misstatement because we care about
aggregated misstatements. Aggregate could be over 70,000
Performance materiality
Boutique Cheeses in the Niagara Region
Inherent Risk
Spoilage perishable
product
Exporting foreign
exchange
Caf Seasonal demand,
selling a product whose
demand can perish (based
valuation on this)
Jim Competing incentives
related party transactions

Control Risk
Effective quality controls
Jim- no controls: pricing,
documentation, sales,
allowances
Lack of communication