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SM 16th Auditing and Assurance Services An Integrated Approach 16th Edition Solution

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  • ISBN-10 ‏ : ‎ 0134075757
  • ISBN-13 ‏ : ‎ 978-0134075754

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SM 16th Auditing and Assurance Services An Integrated Approach 16th Edition Solution

Chapter 9

 

Assessing the Risk of Material Misstatement

 Concept Checks

P. 268

1. The risk of material misstatement exists at two levels: the overall financial statement level and at the assertion level for classes of transactions, account balances, and presentation and disclosures. Auditing standards require the auditor to assess the risk of material misstatement at each of these levels and to plan the audit in response to those assessed risks.

2. To obtain an understanding of the entity and its environment, including the entity’s internal controls, the auditor performs risk assessment procedures to identify and assess the risk of material misstatement, whether due to fraud or error. Risk assessment procedures include the following:
 Inquiries of management and others within the entity
 Analytical procedures
 Observation and inspection
 Discussion among engagement team members
 Other risk assessment procedures

P. 284

1. The audit risk model is as follows:
PDR = AARR
IR x CR

Where PDR = Planned detection risk
AAR = Acceptable audit risk
IR = Inherent risk
CR = Control risk
Planned detection risk A measure of the risk that audit evidence for a segment will fail to detect misstatements that could be material, should such misstatements exist.
Acceptable audit risk A measure of how willing the auditor is to accept that the financial statements may be materially misstated after the audit is completed and an unmodified opinion has been issued.
Inherent risk A measure of the auditor’s assessment of the susceptibility of an assertion to material misstatement before considering the effectiveness of internal control.

Concept Check, P. 284 (continued)

Control risk A measure of the auditor’s assessment of the risk that a material misstatement could occur in an assertion and not be prevented or detected by the client’s internal controls.

Auditing standards note that the combination of inherent risk and control risk reflects the risk of material misstatement.

2. An increase in planned detection risk may be caused by an increase in acceptable audit risk or a decrease in either control risk or inherent risk. A decrease in planned detection risk is caused by the opposite: a decrease in acceptable audit risk or an increase in control risk or inherent risk.

 Review Questions

9-1 The parts of planning are: accept client and perform initial planning, understand the client’s business and industry, perform preliminary analytical procedures, set preliminary judgment of materiality and performance materiality, identify significant risks due to fraud or error, assess inherent risk, understand internal control and assess control risk, and finalize overall audit strategy and audit plan. The evaluation of risk is an explicit component of part five (identify significant risks, including fraud risks), part six (assess inherent risk), and part seven (control risk).

9-2 The risk of material misstatement at the overall financial statement level refers to risks that relate pervasively to the financial statements as a whole and potentially affect a number of different transactions and accounts. It is important for the auditor to consider risks at the overall financial statement level given those risks may increase the likelihood of risks of material misstatement across a number of accounts and assertions for those accounts.

9-3 A number of overarching factors may increase the risks of material misstatement at the overall financial statement level. For example, deficiencies in management’s integrity or competence, ineffective oversight by the board of directors, or inadequate accounting systems and records increase the likelihood that material misstatements may be present in a number of assertions affecting several classes of transactions, account balances, or financial statement disclosures. Similarly, declining economic conditions or significant changes in the industry may increase the risk of material misstatement at the overall financial statement level.

9-4 Concern about the client potentially recording revenues that did not occur would relate to the occurrence transaction-related audit objective. In this case, the auditor would assess the risk of occurrence as high.

9-5 The auditor performs risks assessment procedures to identify and assess the risk of material misstatement, whether due to fraud or error. Risk assessment procedures include the following:
1. Inquiries of management and others within the entity: Because management and others, including those charged with governance and internal audit, have important information to assist the auditor in identifying risks of material misstatements, the auditor will make a number of inquiries of these individuals to understand the entity and its environment, including internal control, and to ask them about their assessments of the risks of material misstatements.
2. Analytical procedures: As noted in Chapter 8, auditors are required to perform preliminary analytical procedures as part of audit planning to better understand the entity and to assess client business risks.
3. Observation and inspection: Auditors observe the entity’s operations and they inspect documents, such as the organization’s strategic plan, business model, and its organizational structure to increase the auditor’s understanding of how the business is structured and how it organizes key business functions and leaders in the oversight of day-to-day operations.
4. Discussion among engagement team members: Auditing standards require the engagement partner and other key engagement team members to discuss the susceptibility of the client’s financial statements to material misstatement. This includes explicit discussion about the susceptibility of the client’s financial statements to fraud, in addition to their susceptibility of material misstatement due to errors.
5. Other risk assessment procedures: The auditor may perform other procedures to assist in the auditor’s assessment of the risk of material misstatement.

9-6 In addition to making inquiries of individuals involved in financial reporting positions, auditors benefit from obtaining information or different perspectives through inquiries of others within the entity and other employees with different levels of authority. Additionally, inquiries of those charged with governance, such as the board of directors or audit committee, may provide important insights about the overall competitive environment and strategy of the business that may provide important insights about overall client business risks. Similarly, because internal auditors typically have exposure to all aspects of the client’s business and operations, they may have important information about risks at the overall financial statement level or assertion level. Most internal audit functions develop their internal audit scope based on a risk assessment process that considers risks to design their audit strategies.

9-7 Auditing standards require the engagement partner and other key engagement team members to discuss the susceptibility of the client’s financial statements to material misstatement. Discussion among the engagement partner and other key members of the engagement team provides an opportunity for more experienced team members, including the engagement partner, to share

9-7 (continued)

their insights about the entity and its environment, including their understanding of internal controls, with other members of the engagement team. The discussion should include an exchange of ideas or brainstorming among the engagement team members about business risks and how and where the financial statements might be susceptible to material misstatement, whether due to fraud or error. By including key members of the engagement team in discussions with the engagement partner, all members of the engagement team become better informed about the potential for material misstatement of the financial statements in specific areas of the audit assigned to them, and it helps them gain an appreciation for how the results of audit procedures performed by them affect other areas of the audit.

9-8 Auditing standards explicitly require that discussion among engagement team members consider the susceptibility of the client’s financial statements to fraud, in addition to their susceptibility of material misstatement due to errors. While auditing standards specifically require a discussion among the key engagement team members, including the engagement partner, about how and where the entity’s financial statements may be susceptible to material misstatement due to fraud, this can be held concurrently with the discussion about the susceptibility of the financial statements to material misstatement due to error. These discussions should include an exchange of ideas or brainstorming among the engagement team members about business risks and how and where the financial statements might be susceptible to material misstatement, whether due to fraud or error.

9-9 While auditors perform risk assessment procedures to assess the risk of material misstatement due to fraud or error, auditing standards require the auditor to explicitly consider fraud risk because the risk of not detecting a material misstatement due to fraud is higher than the risk of not detecting a misstatement due to error. Fraud often involves complex and sophisticated schemes designed by perpetrators to conceal it, such as forgery of approvals and authorizations for unusual cash disbursement transactions or intentional efforts to not record a transaction in the accounting records. And, individuals engaged in conducting a fraud often intentionally misrepresent information to the auditor, and they may try to conceal the transaction through collusion with others. As a result, explicitly focusing on the risks of material misstatements due to fraud helps the auditor apply professional skepticism as part of the auditor’s planning procedures.

9-10 Because a number of high profile instances of fraudulent financial reporting have involved misstatements in revenue recognition, auditing standards require the auditor to presume that risks of fraud exist in revenue recognition. As a result, risks related to audit objectives for revenue transactions and their related account balances and presentation and disclosure are presumed to be significant risks in most audits. If the auditor determines that the presumption is

9-10 (continued)

not applicable to a particular audit engagement, the auditor must document this conclusion in the working papers.

9-11 Auditing standards require the auditor to inquire of management about their assessment of the risk that the financial statements may be materially misstated due to fraud. As part of those inquiries, the auditor should ask management to describe the frequency of management’s assessment and the extent of their consideration of risks due to fraud, including discussion about management’s processes that are designed to identify, respond to, and monitor the risks of fraud in the organization. Auditing standards require the auditor to make inquiries of management and others within the entity about their knowledge of any actual, suspected, or alleged fraud affecting the client and whether management has communicated any information about fraud risks to those charged with governance.

9-12 A significant risk represents an identified and assessed risk of material misstatement that, in the auditor’s professional judgment, requires special audit consideration. Auditing standards require the auditor to obtain an understanding of the entity’s controls relevant to significant risks to evaluate the design and implementation of those controls, and the auditor must perform substantive tests related to assertions deemed to have significant risks.

9-13 Three types of characteristics of transactions and balances that might cause an auditor to determine that a risk of material misstatement is a significant risk:

1. Nonroutine Transactions: Significant risks often relate to significant nonroutine transactions, which represent transactions that are unusual, either due to size or nature, and that are infrequent in occurrence. Nonroutine transactions may increase the risk of material misstatement because they often involve a greater extent of management intervention, including more reliance on manual versus automated data collection and processing, and they can involve complex calculations or unusual accounting principles not subject to effective internal controls due to their infrequent nature. Related party transactions often reflect these characteristics, thereby increasing the likelihood they are considered significant risks.
2. Matters Requiring Significant Judgment: Significant risks also relate to matters that require significant judgment because they include the development of accounting estimates for which significant measurement uncertainty exists. Classes of transactions or account balances that are based on the development of accounting estimates often require significant judgment that is subjective or complex based on assumptions about future events. As a result, those types of transactions or balances frequently are identified as significant risks.
9-13 (continued)

3. Fraud Risk: Because fraud generally involves concealment, detecting material misstatements due to fraud is difficult. As a result, when auditors identify a potential risk of material misstatement due to fraud, auditing standards require the auditor to consider that risk a significant risk, which triggers required responses to those risks.

9-14 Inherent risk and control risk relate to the risk of material misstatement at the assertion level. Inherent risk measures the auditor’s assessment of the susceptibility of an assertion to material misstatement, before considering the effectiveness of related internal controls. Control risk measures the auditor’s assessment of the risk that a material misstatement could occur in an assertion and not be prevented or detected on a timely basis by the client’s internal controls.

9-15 An increase in planned detection risk may be caused by an increase in acceptable audit risk or a decrease in either control risk or inherent risk. A decrease in planned detection risk is caused by the opposite: a decrease in acceptable audit risk or an increase in control risk or inherent risk.

9-16 Inherent risk is a measure of the auditor’s assessment of the susceptibility of an assertion to material misstatements before considering the effectiveness of internal control.
Factors affecting assessment of inherent risk include:
 Nature of the client’s business
 Results of previous audits
 Initial vs. repeat engagement
 Related parties
 Complex or nonroutine transactions
 Judgment required to correctly record transactions
 Makeup of the population
 Factors related to fraudulent financial reporting
 Factors related to misappropriation of assets

9-17 Inherent risk is set for audit objectives for segments rather than for the overall audit because misstatements occur at the objective level within a segment. By identifying expectations of misstatements in segments, the auditor is thereby able to modify audit evidence by searching for misstatements in those segments.
When inherent risk is increased from medium to high, the auditor should increase the audit evidence accumulated to determine whether the expected misstatement actually occurred.

9-18 Extensive misstatements in the prior year’s audit would cause inherent risk to be set at a high level (maybe even 100%). An increase in inherent risk would lead to a decrease in planned detection risk, which would require that the auditor increase the level of planned audit evidence.

9-19 Acceptable audit risk is a measure of how willing the auditor is to accept that the financial statements may be materially misstated after the audit is completed and an unmodified opinion has been issued.
Acceptable audit risk has an inverse relationship to evidence. If acceptable audit risk is reduced, planned evidence should increase.

9-20 When the auditor is in a situation where he or she believes that there is a high exposure to legal liability, the acceptable audit risk would be set lower than when there is little exposure to liability. Even when the auditor believes that there is little exposure to legal liability, there is still a minimum acceptable audit risk that should be met.

9-21 Planned detection risk is the risk that audit evidence for a segment will fail to detect misstatements that could be material, should such misstatements exist. In order to reduce this risk, the auditor would increase the amount of evidence they collect for a specific audit objective. For example, if the auditor wanted a low level of risk that audit procedures designed to test the existence of inventory fail to detect a material misstatement, they would increase the amount of inventory tested and/or the number of audit procedures performed.

9-22 Exact quantification of all components of the audit risk model is not required to use the model in a meaningful way. An understanding of the relationships among model components and the effect that changes in the components have on the amount of evidence needed allow practitioners to use the audit risk model in a meaningful way.

9-23 The auditor should revise the components of the audit risk model when the evidence accumulated during the audit indicates that the auditor’s original assessments of inherent risk or control risk are too low or too high or the original assessment of acceptable audit risk is too low or too high.
The auditor should exercise care in determining the additional amount of evidence that will be required. This should be done without the use of the audit risk model. If the audit risk model is used to determine a revised planned detection risk, there is a danger of not increasing the evidence sufficiently.

9-24 Audit risk is a measure of how willing the auditor is to accept that the financial statements may be materially misstated after the audit is completed and an unmodified opinion has been issued. An auditor cannot assess the risk of material misstatement without first deciding the size of misstatements that will be considered material. Materiality and audit risk are considered together in planning the nature and extent of risk assessment procedures to be performed, identifying and assessing the risks of material misstatement, determining the nature, timing and extent of audit procedures, and evaluating audit findings.
 Multiple Choice Questions From CPA Examinations

9-25 a. (2) b. (1) c (4)

9-26 a. (3) b. (4) c. (3)

9-27 a. (4) b. (1) c. (1)

 Multiple Choice Questions From Becker CPA Exam Review

9-28 a. (2) b. (2) c. (1)

 Discussion Questions And Problems

9-29 a. The following terms are audit planning decisions requiring professional judgment:
 Preliminary judgment about materiality
 Control risk
 Risk of fraud
 Inherent risk
 Risk of material misstatements
 Planned detection risk
 Significant risk
 Acceptable audit risk
 Performance materiality

b. The following terms are audit conclusions resulting from application of audit procedures and requiring professional judgment:
 Estimated total misstatement in a segment
 Estimate of the combined misstatement
 Known misstatement

c. It is acceptable to change any of the factors affecting audit planning decisions at any time in the audit if indicated by changes in circumstances. The planning process begins before the audit starts and continues throughout the engagement. Some of the factors would be least likely to be changed after the audit is 95% completed. For example, the performance materiality or acceptable audit risk would not be raised at the end of the audit after the accumulated audit evidence suggests there are material misstatements that exceed the initial preliminary materiality amount.

9-30 a. PCAOB Auditing Standard No. 12 (paragraph .07) notes that the auditor, when obtaining an understanding of the company and its environment, should obtain an understanding of the following:

1. Relevant industry, regulatory, and other external factors, including the competitiveness of the environment, technological developments, regulations, and the legal and political environment.
2. The nature of the company, including aspects such as its organizational structure, management personnel, sources of
funding, significant investments, operating characteristics, sources of earnings, and key suppliers and customers.
3. The company’s selection and application of accounting principles, including related disclosures, including an evaluation of whether they are appropriate for its business and consistent with GAAP and with those used in the industry;
4. The company’s objectives and strategies and those related business risks that might reasonably be expected to result in risks of material misstatement; and
5. The company’s measurement and analysis of its financial performance, including an assessment of how performance measures, whether internal or external, affect the risk of material misstatement.

In obtaining an understanding of the company, the auditor should evaluate whether significant changes in the company from prior periods, including changes in its internal control over financial reporting, affect the risks of material misstatement.

b. Paragraph .17 of PCAOB Auditing Standard No. 12 provides two examples of performance measures that create incentives or pressures for management to manipulate certain accounts or disclosures to achieve performance targets:
• Measures that form the basis for contractual commitments or incentive compensation plans
• Measures used by external parties, such as analysts and rating agencies, to review the company’s performance

PCAOB Auditing Standard No. 12 also provides the following example of a performance measure that management might use to monitor risks affecting the financial statements:
• Measures the company uses to monitor its operations that highlight unexpected results or trends that prompt management to investigate their cause and take corrective action, including the correction of misstatements.

9-30 (continued)

c. Paragraphs .49 through .53 of PCAOB Auditing Standard No. 12 require the engagement team members to discuss (1) the company’s selection and application of accounting principles, including related disclosure requirements, and (2) the susceptibility of the company’s financial statements to material misstatements due to error or fraud. The discussion of potential for material misstatement due to fraud can be done either as part of the discussion regarding risks of material misstatement due to error or separately. Communication about significant matters affecting the risks of material misstatement should continue throughout the audit.
The discussion should include how and where the financial statements might be susceptible to material misstatement, and it should consider known external and internal factors affecting the company that might create incentives or pressures to commit fraud, opportunities to perpetrate the fraud, or indicate a culture or environment that enables management to rationalize committing fraud. The team should also discuss the potential for management override of controls.

d. When determining whether an identified and assessed risk is a significant risk, paragraphs .70 and .71 of PCAOB Auditing Standard No. 12 note that the determination is based on inherent risk, without regard to the effect of controls. AS No.12 notes that the following factors should be considered:
• The effect of the quantitative and qualitative risk factors on the likelihood and potential magnitude of misstatements
• Whether the risk is a fraud risk (i.e., a fraud risk is a significant risk)
• Whether the risk is related to recent significant economic, accounting, or other developments
• The complexity of transactions
• Whether the risk involves significant transactions with related parties
• The degree of complexity or judgment in the recognition or measurement of financial information related to the risk, especially those measurements involving a wide range of measurement uncertainty, and
• Whether the risk involves significant unusual transactions

e. Paragraph .74 of PCAOB Auditing Standard No. 12 notes that the auditor’s assessment of the risks of material misstatement, including fraud risks, should continue throughout the audit. When the auditor obtains audit evidence during the course of the audit that contradicts the audit evidence on which the auditor originally based his or her risk

9-30 (continued)

assessment, the auditor should revise the risk assessment and modify planned audit procedures or perform additional procedures in response to the revised risk assessments.

9-31 a. Several of the recent developments at Highland Bank and Trust may trigger risks of material misstatement at the financial statement level, including the following:
• The integration of the pending acquisition of the small community bank into Highland’s operations and financial reporting processes may trigger the potential for misstatements across a number of accounts that must be integrated into the financial reporting system. The accounting for assets and liabilities acquired can be complex and there are a number of valuation and disclosures issues that may lead to increased risks of misstatements in those accounts and disclosures.
• Any challenges associated with the integration of IT systems of the acquired bank with Highland’s systems could trigger errors in a number of financial statement accounts, if the IT systems affected impact financial reporting.
• The integrity and competency of personnel from the acquired bank who join Highland could have a pervasive impact on the quality of financial reporting of the combined bank, if they lack integrity or competency.
• Challenges associated with retaining key personnel with IT skills could have a pervasive effect on a number of financial statement accounts, if those individuals leave Highland and there are issues related to the performance of IT systems that impact financial reporting.
• The expansion of online service options for customers could trigger risks across a number of accounts, given customers use online options to make deposits and withdraw funds from both checking and savings accounts. As online service options increase, more financial statement accounts may be impacted.

b. Several of the recent developments at Highland Bank and Trust may trigger risks of material misstatement at the assertion level, including the following:
• The expansion of online service operations may affect the occurrence, completeness, and accuracy of checking and savings account transactions. If there are flaws in the online system, deposits might be overstated due to fictitious deposits or errors in the amounts recorded, thereby affecting the occurrence and accuracy assertions related to those transactions. If transactions are not properly posted to the correct customer accounts,

9-31 (continued)

misstatements related to the posting and summarization transaction-related audit objective may occur.
• Challenges related to credit evaluation may ultimately lead to misstatements in the allowance for loan loss reserves, impacting the realizable value balance-related audit objective (the valuation and allocation assertion). Risks of material misstatements may also affect several of the presentation and disclosure related assertions for loans outstanding, including disclosures related to loan loss reserves.
The expansion into new types of investments subject to fair value accounting where the bank does not have employees with the appropriate valuation skills and competencies increases the risks of material misstatement related to the accuracy and realizable value balance related audit objectives, which impact the valuation and allocation assertion. Risks of material misstatements may also affect several of the presentation and disclosure assertions for investments.

c. Given the significance of these recent events, the risks noted in answers to part a. and b. would most likely be deemed as significant risks in the current year’s audit.

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