RISK ASSESSMENT AND MATERIALITY
Answers to Review Questions
Audit risk is the risk that the auditor may unknowingly fail to appropriately modify the opinion on a set of financial statements that are materially misstated. Engagement risk is the exposure to loss or injury to professional practice from litigation, adverse publicity, or other events arising in connection with financial statements audited and reported on. In simple terms, audit risk is the risk that an auditor will issue an unqualified opinion on materially misstated financial statements, while engagement risk relates to the auditor's exposure to financial loss and damage to his or her professional reputation.
Inherent risk and control risk differ from detection risk in that inherent risk and control risk exist independent of the audit. The levels of inherent risk and control risk are functions of the client and its environment, and the auditor has little control over these risks. The auditor can control detection risk through the scope (nature, timing, and extent) of the audit procedures performed. Thus, detection risk has an inverse relationship with inherent risk and control risk.
The audit risk model has a number of limitations. First, since the auditor assesses inherent risk and control risk, such assessments may be higher or lower than the actual inherent risk and control risk that exist for the client. Second, the audit risk model does not consider the possibility of nonsampling risk (auditor error in assessing risk, choosing audit procedures, and evaluating results).
Sampling risk refers to the fact that, in many instances, the auditor does not examine 100 percent of the class of transactions or account balance. Since only a subset of the population is examined, it is possible that the sample drawn is not representative of the population and a wrong conclusion may be made on the fairness of the account balance. Nonsampling risk occurs because an auditor may use an inappropriate audit procedure, fail to detect a misstatement when applying an appropriate audit procedure, or misinterpret an audit result.
In understanding the entity and its environment, the auditor gathers knowledge about: (1) the nature of the entity; (2) industry, regulatory, and other external factors; (3) objectives and strategies and related business risks; (4) entity performance measures; and (5) internal control.
Some examples of conditions and events that may indicate the existence of business risks are: • Significant changes in the entity such as large acquisitions, reorganizations, or other unusual events. • Significant changes in the industry in which the entity operates. • Significant new products or services or significant new lines of business. • New locations.
• Significant changes in the IT environment.
• Operations in areas with unstable economies.
• High degree of complex regulation.
Auditing standards define errors as unintentional misstatements or omissions of amounts or disclosures in financial statements. Fraud is defined as intentional misstatements that can be classified into two types: (1) misstatements arising from fraudulent financial reporting and (2) misstatements arising from misappropriation of assets. Some examples of misstatements due to errors or fraud include: • An inaccuracy in gathering or processing data from which financial statements are prepared. • A difference between the amount of a reported financial statement account and the amount that would have been reported under GAAP. • The omission of a financial statement element, account, or item. • An incorrect accounting estimate arising from an oversight or misinterpretation of facts.
Professional standards provide very little specific guidance on how to assess what is material to a reasonable user. As a result, auditing firms...
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