Audit risk and risk assessment procedures //
Audit risk and risk assessment procedures, definitions, audit risk and assurance, components of audit risk.
- inherent risk , relating to the nature of the entity;
- control risk , concerning the entity's controls; and
- detection risk - the risk that the auditor does not detect deviations.
Audit risk model
When to consider audit risk.
- planning the audit, including the design of audit procedures;
- carrying out audit procedures; and
- evaluating the results of the audit tests carried out.
Procedures to identify and assess risk.
- the entity and its environment , thereby identifying the inherent risks in the area under consideration, including risks as regards related parties and fraud;
- the internal control arrangements at each relevant level (Commission, member state, intermediary, beneficiary), to help identify the control risks .
The entity’s own risk-assessment
- the Directorate-General’s [link new-window title="annual%20management%20plan" link="https%3A%2F%2Fec.europa.eu%2Finfo%2Fpublications%2Fmanagement-plans_en" icon="external-link" /] (MP) contains objectives, indicators and the critical risks identified for the Directorate-General (DG) concerned;
- the information in the Commission's [link new-window title="annual%20management%20reports" link="https%3A%2F%2Fec.europa.eu%2Finfo%2Fpublications%2Fannual-management-and-performance-reports_en" icon="external-link" /] (AMPR) and the [link new-window title="annual%20activity%20reports" link="https%3A%2F%2Fec.europa.eu%2Finfo%2Fpublications%2Fannual-activity-reports_en" icon="external-link" /] (AAR) including declarations by the Directors-General for the preceding financial year(s) (the AAR provides an overview of critical risks encountered and their impact on the achievement of the DG's objectives);
- relevant reports by the various control bodies of the Commission (including the internal audit service ) and member states, or other auditors;
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The auditor’s risk assessment and response: understanding and applying the requirements
International Standard on Auditing (ISA) 315 (Revised) Identifying and assessing the risks of material misstatement through understanding the entity and its environment explains auditors’ responsibilities in relation to risk assessment and internal control.
The identification and assessment of the risks of material misstatement by the auditor provide the basis for designing and implementing responses to them, which is addressed by ISA 330 The Auditor’s responses to assessed risks. ISA 315 is the ISA from which all other ISAs flow, and all ISAs are risk-based. Many auditors struggle to apply ISAs to small, less complex audits. This maybe due to a lack of understanding or because of the requirements in the ISAs themselves.
Risk assessment challenges for auditors
Risk assessment is critical to the performance of all financial statement audits. The idea of a “risk-based” approach to auditing has been around for many years, and it is not a difficult concept: the approach focuses audit effort on those areas that are most at risk of material misstatement. So, when planning an audit, the audit team would therefore be asking themselves:
- What are the areas of risk?
- How big is the threat of material misstatement associated with these risks?
- What audit procedures need to be performed to respond to the levels of risk assessed?
But both auditors and regulators report problems in applying the relevant auditing standards consistently. Key risk assessment issues include:
- The quality of linkages between risk assessment and response;
- The need to demonstrate and document how professional judgement was applied; and
- The definition, determination and understanding of ‘significant risk’ under the ISAs.
- Visit our guide on risk assessment challenges for auditors
Understanding, documenting and testing internal control
Internal control is an area in which auditors often need to improve their risk assessment processes. In particular, auditors need to remember that internal controls are still relevant where a fully substantive audit approach is adopted. Understanding internal control and documenting that understanding is a challenge for all audits, irrespective of the client’s size or complexity. In smaller, less complex entities controls are typically informal and undocumented, and potentially compromised by a lack of segregation of duties. The involvement of the owner-manager in the day-to-day running of the business can have a positive and a negative effect on the evaluation of risk.
Even where auditors adopt a fully substantive approach, they should ask themselves whether they have:
- identified those controls that are relevant to the audit, such as those relating to the key transaction streams;
- checked whether those controls are designed appropriately to achieve their objectives; and
- obtained evidence that these controls have been implemented, eg, by walkthrough tests.
- Visit our guide on understanding, documenting and testing internal controls and implications for smaller entity audits.
- Visit our guide on practical considerations and examples of the types of work to be performed when obtaining an understanding of the design and implementation of internal control components.
The new ISA 315 (Revised): changes for 2022
The International Audit and Assurance Standards Board (IAASB) approved major changes to ISA 315 in September 2019. The changes will be effective for audits of financial statements for periods beginning on or after 15 December 2021. The effects of the revisions will be far-reaching and will require firms of all sizes to revise their approach to risk assessments.
Determining and applying materiality
The concept of materiality is fundamental to the audit. As the basis for the auditor’s opinion, ISAs require auditors to obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement. Materiality is applied by auditors at the planning stage, and when performing the audit and evaluating the effect of identified misstatements on the audit and of uncorrected misstatements, if any, on the financial statements.
ISA 320 Materiality in planning and performing an audit does not include a definition for materiality. This is because the principle of materiality is first and foremost a financial reporting, rather than an auditing, concept. Also, the interpretation may differ in different parts of the world.
Financial reporting frameworks often discuss the concept of materiality in the context of the preparation and presentation of financial statements. It is important therefore that auditors refer to any discussion of materiality in the financial reporting framework when determining materiality for the audit. Such a discussion, if present, provides auditors with a frame of reference.
- Visit our guide to the ISA requirements.
Using data analytics in external audit
Auditor data analytics is about enhancing audit quality. Data analytics consists of tools that extract, validate and analyse large volumes of data, quickly. The tools are applied to complete populations, 100% of the transactions, ie, “full data sets”, and they can be used to support judgements, draw conclusions or provide direction for further investigation. Auditing standards do not specifically address the use of data analytics in external audit.
Data analytics may be more commonly used in larger firms and the mid-tier, but smaller firms need to be aware of the potential for data analytics to transform smaller audits.
- Visit our guide on developments in this area and the opportunities and challenges for auditors.
Addressing the risk of management override
Management override refers to the ability of management and/or those charged with governance to manipulate accounting records and prepare fraudulent financial statements by overriding controls, even where the controls might otherwise appear to be operating effectively.
Under ISA 240 The auditor’s responsibilities relating to fraud in an audit of financial statements auditors are required to assess the risk of material misstatement from management override of controls as significant, which requires specific documentation and affects the response of the auditor to risk.
Although the level of risk of management override of controls will vary from entity to entity it is, nevertheless, present in all entities.
- Visit our ISA (UK) guide to the auditor’s assessment of the risk of management override
- Visit our ISA (international) guide to the auditor’s assessment of the risk of management override
Communications with those charged with governance
Identifying who is charged with governance, ensuring appropriate communication takes place and demonstrating this on the audit file are vital to the success of the audit of financial statements. ISA 260 (Revised) Communication with those charged with governance provides an overarching framework for the auditor’s communication with those charged with governance and includes specific matters that need to be communicated to them. In addition, a further standard, ISA 265 Communicating deficiencies in internal control to those charged with governance and management includes specific requirements regarding communicating significant deficiencies in internal controls identified by the auditor in the course of the audit.
Communicating effectively throughout the audit can improve its technical quality and cost effectiveness for entities of all shapes and sizes. Communication is not something you just have to do because International Standards on Auditing (ISAs) require it; it is something you should want to do in order to improve the audit.
Many audit files give good evidence of communication with management at the completion stage, but ISA 260 requires the audit team to establish effective two-way communication throughout the audit process. This means that the audit file should demonstrate a consistent level of communication throughout the audit.
- Visit our guide to the ISA (UK) requirements on communicating with those charged with governance and how to apply them to small entity audits.
- Visit our guide to the ISA (international) requirements on communicating with those charged with governance and how to apply them to small entity audits .
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Relevant to FAU, AA and AAA
This article outlines and explains the concept of audit risk, making reference to the key auditing standards which give guidance to auditors about risk assessment
Identifying and assessing audit risk is a key part of the audit process, and ISA 315, Identifying and Assessing the Risks of Material Misstatement Through Understanding the Entity and Its Environment , gives extensive guidance to auditors about audit risk assessment. The purpose of this article is to give summary guidance to FAU, AA and AAA students about the concept of audit risk. All subsequent references in this article to the standard will be stated simply as ISA 315, although ISA 315 is a ‘redrafted’ standard, in accordance with the International Auditing and Assurance Standards Board (IAASB) Clarity Project. For further details on the IAASB Clarity Project, read the article 'The IAASB Clarity Project' (see 'Related links').
What is audit risk?
According to the IAASB Glossary of Terms (1), audit risk is defined as follows:
‘The risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated. Audit risk is a function of material misstatement and detection risk.’
Why is audit risk so important to auditors?
Audit risk is fundamental to the audit process because auditors cannot and do not attempt to check all transactions. Students should refer to any published accounts of large companies and think about the vast number of transactions in a statement of comprehensive income and a statement of financial position. It would be impossible to check all of these transactions, and no one would be prepared to pay for the auditors to do so, hence the importance of the risk‑based approach toward auditing. Traditionally, auditors have used a risk-based approach in order to minimise the chance of giving an inappropriate audit opinion, and audits conducted in accordance with ISAs must follow the risk‑based approach, which should also help to ensure that audit work is carried out efficiently, using the most effective tests based on the audit risk assessment. Auditors should direct audit work to the key risks (sometimes also described as significant risks), where it is more likely that errors in transactions and balances will lead to a material misstatement in the financial statements. It would be inefficient to address insignificant risks in a high level of detail, and whether a risk is classified as a key risk or not is a matter of judgment for the auditor.
There are many references throughout the ISAs to audit risk, but perhaps the two most important audit risk-related ISAs are as follows:
ISA 200, Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with ISAs ISA 200 sets out the overall objectives of the auditor, and the standard explains the nature and scope of an audit designed to enable an auditor to meet those objectives. References to audit risk are frequently made by ISA 200, and the standard also requires that the auditor shall plan and perform an audit with professional scepticism, recognising that circumstances might exist that may cause the financial statements to be materially misstated. Professional scepticism is defined as an attitude that includes a questioning mind and a critical assessment of evidence.
ISA 315, Identifying and Assessing the Risks of Material Misstatement Through Understanding the Entity and Its Environment ISA 315 deals with the auditor’s responsibility to identify and assess the risks of material misstatement in the financial statements through an understanding of the entity and its environment, including the entity’s internal controls and risk assessment process. The first version of ISA 315 was originally published in 2003 after a joint audit risk project had been carried out between the IAASB, and the United States Auditing Standards Board. Changes in the audit risk standards have arguably been the single biggest change in auditing standards in recent years, so the significance of ISA 315, and the topic of audit risk, should not be underestimated by auditing students.
The requirements of ISA 315 are summarised in the following table.
Let us consider each of these four stages in more detail.
1. Risk assessment procedures ISA 315 gives an overview of the procedures that the auditor should follow in order to obtain an understanding sufficient to assess audit risks, and these risks must then be considered when designing the audit plan. ISA 315 goes on to require that the auditor shall perform risk assessment procedures to provide a basis for the identification and assessment of risks of material misstatement at the financial statement and assertion levels. ISA 315 goes on to identify the following three risk assessment procedures:
Making inquiries of management and others within the entity Auditors must have discussions with the client’s management about its objectives and expectations, and its plans for achieving those goals.
Analytical procedures Analytical procedures performed as risk assessment procedures should help the auditor in identifying unusual transactions or positions. They may identify aspects of the entity of which the auditor was unaware, and may assist in assessing the risks of material misstatement in order to provide a basis for designing and implementing responses to the assessed risks.
Observation and inspection Observation and inspection may also provide information about the entity and its environment. Examples of such audit procedures can potentially cover a very broad area, including observation or inspection of the entity’s operations, documents, and reports prepared by management, and also of the entity’s premises and plant facilities.
ISA 315 requires that risk assessment procedures should, at a minimum, comprise a combination of the above three procedures, and the standard also requires that the engagement partner and other key engagement team members should discuss the susceptibility of the entity’s financial statements to material misstatement. Key risks can be identified at any stage of the audit process, and ISA 315 requires that the engagement partner should also determine which matters are to be communicated to those engagement team members not involved in the discussion.
2. Understanding an entity ISA 315 gives detailed guidance about the understanding required of the entity and its environment by auditors, including the entity’s internal control systems. Understanding of the entity and its environment is important for the auditor in order to help identify the risks of material misstatement, to provide a basis for designing and implementing responses to assessed risk (see reference below to ISA 330, The Auditor’s Responses to Assessed Risks ), and to ensure that sufficient appropriate audit evidence is collected. Given that the focus of this article is audit risk, however, students should ensure that they also make themselves familiar with the concept of internal control, and the components of internal control systems.
3. Identification and assessment of significant risks and the risks of material misstatement In exercising judgement as to which risks are significant risks, the auditor is required to consider the following:
- Whether the risk is a risk of fraud.
- Whether the risk is related to recent significant economic, accounting or other developments, and therefore requires specific attention.
- The complexity of transactions.
- Whether the risk involves significant transactions with related parties.
- The degree of subjectivity in the measurement of financial information related to the risk, especially those measurements involving a wide range of measurement uncertainty.
- Whether the risk involves significant transactions that are outside the normal course of business for the entity, or that otherwise appear to be unusual.
4. ISA 330 and responses to assessed risks The requirements of ISA 330, The Auditor’s Responses to Assessed Risks , will be covered in a future article, but essentially ISA 330 gives guidance about the nature and extent of the testing required, based on the risk assessment findings.
Audit risk and business risk
For the purposes of the F8 exam, it is important to make a distinction between audit risk and business risk (which is not examinable in F8), even though ISA 315 itself does not make such a distinction clear. ISA 315(2) defines business risk as follows:
‘A risk resulting from significant conditions, events, circumstances, actions or inactions that could adversely affect an entity’s ability to achieve its objectives and execute its strategies, or from the setting of inappropriate objectives and strategies.’
Hence, business risk is a much broader concept than audit risk. Students are reminded that business risk is excluded from the FAU and F8 syllabus, although it is examinable in P7.
The audit risk model
Finally, it is important to make reference to the so called traditional audit risk model, which pre-dates ISA 315, but continues to remain important to the audit process. The audit risk model breaks audit risk down into the following three components:
Inherent risk This is the susceptibility of an assertion about a class of transaction, account balance, or disclosure to a misstatement that could be material, either individually or when aggregated with other misstatements, before consideration of any related controls.
Control risk This is the risk that a misstatement could occur in an assertion about a class of transaction, account balance or disclosure, and that the misstatement could be material, either individually or when aggregated with other misstatements, and will not be prevented or detected and corrected, on a timely basis, by the entity’s internal control.
Detection risk This is the risk that the procedures performed by the auditor to reduce audit risk to an acceptably low level will not detect a misstatement that exists and that could be material, either individually or when aggregated with other misstatements. The interrelationship of the three components of audit risk is outside the scope of this current article. F8 students, however, will typically be expected to have a good understanding of the concept of audit risk, and to be able to apply this understanding to questions in order to identify and describe appropriate risk assessment procedures.
The UK and Ireland perspective
The UK Auditing Practices Board announced in March 2009 that it would update its auditing standards according to the clarified ISAs, and that these standards would apply for audits of accounting periods ending on or after 15 December 2010. UK and Irish students should note that there are no significant differences on audit risk between ISA 315 and the UK and Ireland version of the standard.
The concept of audit risk is of key importance to the audit process and F8 students are required to have a good understanding of what audit risk is, and why it is so important. For the purposes of the F8 exam, it is important to understand that audit risk is a very practical topic and is therefore examined in a very practical context. Any definition or explanation of the audit risk model itself will usually only be allocated a small number of marks, but many students still include such definitions in answers to case study and scenario questions which require a practical application of audit risk assessment procedures. Students must also be prepared to apply their understanding of audit risk to questions and come up with appropriate risk assessment procedures.
Written by a member of the F8 examining team
- IAASB Handbook 2009, Glossary of Terms.
- ISA 315, Identifying and Assessing the Risks of Material Misstatement Through Understanding the Entity and Its Environment , paragraph 4 (b).
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- Risk Assessment Process
Risk assessment is the identification and analysis of relevant risks to the achievement of an organization's objectives, for the purpose of determining how those risks should be managed.
During the risk assessment process, Internal Auditing identifies and assesses both the likelihood and potential impact of various risks to the organization. Internal controls are then identified and evaluated to determine how adequate they are in reducing risk to ensure that residual risk is at manageable levels. Residual risk is the risk that something will occur after controls or procedures are implemented to prevent it. In addition to audits required by state regulations, those activities or functions with higher levels of residual risk are typically selected for audits.
Developing the Audit Plan:
The WIU Office of Internal Auditing develops the annual audit plan using a risk-based approach. The annual risk assessment process occurs in late spring or early summer to facilitate the development of a two-year audit plan. Internal Auditing conducts the risk assessment process through discussions with management; review and analysis of budgets and proposed programs; and a systematic evaluation of risk factors covering the functional and organizational units of the University. Based upon the results of the risk analysis, a proposed audit plan is presented to the Senior Executive Cabinet for their review and approval. Upon consensus by the Cabinet, the audit plan is submitted to the University President for approval. Next, the audit plan is presented to the University Board of Trustees Audit Committee for their review and approval. The two-year plan is updated annually and may be modified as unplanned issues of potential risk are identified throughout the year. The plan is required to be completed before June 30 th of each year for the next two fiscal year periods.
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- Audit Risk Assessment: The Why and the How
By Charles Hall | Auditing
- You are here:
Today we look at one of most misunderstood parts of auditing: audit risk assessment.
Are auditors leaving money on the table by avoiding risk assessment? Can inadequate risk assessment lead to peer review findings? This article shows you how to make more money and create higher quality audit documentation . Below you’ll see how to use risk assessment procedures to identify risks of material misstatement. You’ll also learn about the risk of material misstatement formula and how you can use it to plan your engagements.
Audit Risk Assessment as a Friend
Audit risk assessment can be our best friend, particularly if we desire efficiency, effectiveness, and profit —and who doesn’t?
This step, when properly performed, tells us what to do—and what can be omitted. In other words, risk assessment creates efficiency.
So, why do some auditors (intentionally) avoid audit risk assessment? Here are two reasons:
- We don’t understand it
- We’re creatures of habit
Too often auditors continue doing the same as last year (commonly referred to as SALY)–no matter what. It’s more comfortable than using risk assessment.
But what if SALY is faulty or inefficient?
Maybe it’s better to assess risk annually and to plan our work accordingly (based on current conditions).
Are We Working Backwards?
The old maxim “Plan your work, work your plan” is true in audits. Audits—according to standards—should flow as follows:
- Determine the risks of material misstatements (plan our work)
- Develop a plan to address those risks (plan our work)
- Perform substantive procedures (work our plan) and tests controls for effectiveness (if planned)
- Issue an opinion (the result of planning and working)
Auditors sometimes go directly to step 3. and use the prior year audit programs to satisfy step 2. Later, before the opinion is issued, the documentation for step 1. is created “because we have to.”
In other words, we work backwards .
So, is there a better way?
A Better Way to Audit
During the initial planning phase of an audit, an auditor should do the following:
- Understand the entity and its environment
- Understand entity-level controls
- Understand the transaction level controls
- Use preliminary analytical procedures to identify risk
- Perform fraud risk analysis
- Assess risk
While we may not complete these steps in this order, we do need to perform our risk assessment first (1.-4.) and then assess risk .
Okay, so what procedures should we use?
Audit Risk Assessment Procedures
AU-C 315.06 states:
The risk assessment procedures should include the following:
- Inquiries of management, appropriate individuals within the internal audit function (if such function exists), others within the entity who, in the auditor’s professional judgment, may have information that is likely to assist in identifying risks of material misstatement due to fraud or error
- Analytical procedures
- Observation and inspection
I like to think of risk assessment procedures as detective tools used to sift through information and identify risk.
Just as a good detective uses fingerprints, lab results, and photographs to paint a picture, we are doing the same.
First, we need to understand the entity and its environment.
Understand the Entity and Its Environment
The audit standards require that we understand the entity and its environment.
I like to start by asking management this question: “If you had a magic wand that you could wave over the business and fix one problem, what would it be?”
The answer tells me a great deal about the entity’s risk.
I want to know what the owners and management think and feel . Every business leader worries about something . And understanding fear illuminates risk.
Think of risks as threats to objectives. Your client’s fears tell you what the objectives are–and the threats.
To understand the entity and its related threats, ask questions such as:
- How is the industry faring?
- Are there any new competitive pressures or opportunities?
- Have key vendor relationships changed?
- Can the company obtain necessary knowledge or products?
- Are there pricing pressures?
- How strong is the company’s cash flow?
- Has the company met its debt obligations?
- Is the company increasing in market share?
- Who are your key personnel and why are they important?
- What is the company’s strategy?
- Does the company have any related party transactions?
As with all risks, we respond based on severity . The higher the risk, the greater the response.
Audit standards require that we respond to risks at these levels:
- Financial statement level
- Transaction level
Responses to risk at the financial statement level are general, such as appointing more experienced staff for complex engagements.
Responses to risk at the transaction level are more specific such as a search for unrecorded liabilities.
But before we determine responses, we must first understand the entity’s controls.
Understand Transaction Level Controls
We must do more than just understand transaction flows (e.g., receipts are deposited in a particular bank account). We need to understand the related controls (e.g., Who enters the receipt in the general ledger? Who reviews receipting activity?).
So, as we perform walkthroughs or other risk assessment procedures, we gain an understanding of the transaction cycle , but—more importantly—we gain an understanding of controls. Without appropriate controls, the risk of material misstatement increases.
AU-C 315.14 requires that auditors evaluate the design of their client’s controls and to determine whether they have been implemented . However, AICPA Peer Review Program statistics indicate that many auditors do not meet this requirement. In fact, noncompliance in this area is nearly twice as high as any other requirement of AU-C 315 – Understanding the Entity and Its Environment and Assessing the Risk of Material Misstatement .
Some auditors excuse themselves from this audit requirement saying, “the entity has no controls.”
All entities have some level of controls. For example, signatures on checks are restricted to certain person. Additionally, someone usually reviews the financial statements. And we could go on.
The AICPA has developed a practice aid that you’ll find handy in identifying internal controls in small entities.
The use of walkthroughs is probably the best way to understand internal controls.
Sample Walkthrough Questions
As you perform your walkthroughs, ask questions such as:
- Who signs checks?
- Who has access to checks (or electronic payment ability)?
- Who approves payments?
- Who initiates purchases?
- Who can open and close bank accounts?
- Who posts payments?
- What software is used? Does it provide an adequate audit trail? Is the data protected? Are passwords used?
- Who receives and opens bank statements? Does anyone have online access? Are cleared checks reviewed for appropriateness?
- Who reconciles the bank statement? How quickly? Does a second person review the bank reconciliation?
- Who creates expense reports and who reviews them?
- Who bills clients? In what form (paper or electronic)?
- Who opens the mail?
- Who receipts monies?
- Are there electronic payments?
- Who receives cash onsite and where?
- Who has credit cards? What are the spending limits?
- Who makes deposits (and how)?
- Who keys the receipts into the software?
- What revenue reports are created and reviewed? Who reviews them?
- Who creates the monthly financial statements? Who receives them?
- Are there any outside parties that receive financial statements? Who are they?
Understanding the company’s controls illuminates risk. The company’s goal is to create financial statements without material misstatement. And a lack of controls threatens this objective.
So, as we perform walkthroughs, we ask the payables clerk (for example) certain questions. And—as we do—we are also making observations about the segregation of duties. Also, we are inspecting certain documents such as purchase orders.
This combination of inquiries, observations, and inspections allows us to understand where the risk of material misstatement is highest.
In a AICPA study regarding risk assessment deficiencies, 40% of the identified violations related to a failure to gain an understanding of internal controls.
Need help with risk assessment walkthroughs?
See my article Audit Walkthroughs: The What, Why, How, and When .
Get my new book:
Audit risk assessment made easy.
Click here to see it on Amazon.
Another significant risk identification tool is the use of planning analytics.
Preliminary Analytical Procedures
Use planning analytics to shine the light on risks. How? I like to use:
- Multiple-year comparisons of key numbers (at least three years, if possible)
In creating preliminary analytics, use management’s metrics. If certain numbers are important to the company, they should be to us (the auditors) as well— there’s a reason the board or the owners are reviewing particular numbers so closely . (When you read the minutes, ask for a sample monthly financial report; then you’ll know what is most important to management and those charged with governance.)
You may wonder if you can create planning analytics for first-year businesses. Yes, you can. Compare monthly or quarterly numbers. Or you might compute and compare ratios (e.g., gross profit margin) with industry benchmarks. (For more information about, see my preliminary analytics post.)
Sometimes, unexplained variations in the numbers are fraud signals.
Identify Fraud Risks
In every audit, inquire about the existence of theft. In performing walkthroughs, look for control weaknesses that might allow fraud to occur. Ask if any theft has occurred. If yes, how?
Also, we should plan procedures related to:
- Management override of controls, and
- The intentional overstatement of revenues
My next post —in The Why and How of Auditing series—addresses fraud, so this is all I will say about theft, for now. Sometimes the greater risk is not fraud but errors.
Same Old Errors
Have you ever noticed that some clients make the same mistakes—every year? (Johnny–the controller–has worked there for the last twenty years, and he makes the same mistakes every year. Sound familiar?) In the risk assessment process, we are looking for the risk of material misstatement whether by intention (fraud) or by error (accident).
One way to identify potential misstatements due to error is to maintain a summary of the larger audit entries you’ve made over the last three years. If your client tends to make the same mistakes, you’ll know where to look.
Now it’s time to pull the above together.
Creating the Risk Picture
Once all of the risk assessment procedures are completed, we synthesize the disparate pieces of information into a composite image .
What are we bringing together? Here are examples:
- Control weaknesses
- Unexpected variances in significant numbers
- Entity risk characteristics (e.g., level of competition)
- Large related-party transactions
- Occurrences of theft
Armed with this risk picture, we can now create our audit strategy and audit plan (also called an audit program). F ocus these plans on the higher risk areas.
How can we determine where risk is highest? Use the risk of material misstatement (RMM) formula.
Assess the Risk of Material Misstatement
Understanding the risk of material misstatement formula is key to identifying high-risk areas.
What is the risk of material misstatement formula?
Put simply, it is:
Risk of Material Misstatement = Inherent Risk X Control Risk
Using the RMM formula, we are assessing risk at the assertion level. While audit standards don’t require a separate assessment of inherent risk and control risk, consider doing so anyway. I think it provides a better representation of your risk of material misstatement.
Here’s a short video about assessing inherent risk.
And another video regarding control risk assessment.
Once you have completed the risk assessment process, control risk can be assessed at high–simply as an efficiency decision . See my article Assessing Audit Control Risk at High and Saving Time .
The Input and Output
The inputs in audit planning include all of the above audit risk assessment procedures.
The outputs (sometimes called linkage) of the audit risk assessment process are:
- Audit strategy
- Audit plan (audit programs)
We tailor the strategy and plan based on the risks..
In a nutshell, we identify risks and respond to them.
Next in the Audit Series
In my next post, we’ll take a look at Auditing for Fraud: The Why and How .
Audit Risk Assessment Made Easy – My New Book
My new book titled Audit Risk Assessment Made Easy is now available on Amazon. I’ve been working on this for over a year and a half. I think you’ll find it to be a valuable resource in understanding, documenting, planning, and performing risk assessment procedures.
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About the Author
Charles Hall is a practicing CPA and Certified Fraud Examiner. For the last thirty years, he has primarily audited governments, nonprofits, and small businesses. He is the author of The Little Book of Local Government Fraud Prevention and Preparation of Financial Statements & Compilation Engagements. He frequently speaks at continuing education events. Charles is the quality control partner for McNair, McLemore, Middlebrooks & Co. where he provides daily audit and accounting assistance to over 65 CPAs. In addition, he consults with other CPA firms, assisting them with auditing and accounting issues.
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Bobby, We still use the summary risk assessment form from PPC. Not sure about the peer review comment. Significant risks are those that require special attention; they are usually complex estimates. Significant risks always result in high inherent risk.
Any control risks assessed at below high must be supported by a test of controls (e.g., test of 40 transactions to see if the control is working).
All significant accounts (those with a high volume of transactions such as cash) or significant balances require some type of substantive procedures, even if the risk of material misstatement is low.
Hope this helps.
I summarize all risks of material misstatements on my summary risk assessment form. This form was no longer available. Any way you can email? I use the PPC form and interested in your design. If the control environment is strong – low risk and control risk is low from strong controls the risk of material misstatement would not be considered Significant. However, if the account balance was material it could still be considered a Sig Risk with expanded audit procedures? Just had a peer review remark a while ago that questioned why we indicated a sig risk for the aforementioned scenario.
Appreciate your input
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What is Audit Risk & How to do Risk Assessment?
The audit is the inspection of an organization's accounts, followed by a physical inventory check to ensure all departments maintain a documented system of documenting transactions.
It is done to make sure the organization's financial accounts are accurate. Let us see in detail about Audit Risk assessment Procedures and Auditor approach to Risk assessment .
What is Audit risk?
Audit risk is when the Auditor fails to detect errors while examining the financial statements of a company and can be solved with a good risk assessment. Audit risk can be managed by auditors through appropriate risk assessment and audit planning. This includes identifying and evaluating inherent and control risks and developing appropriate audit procedures to address those risks. Furthermore, Auditing firms should have malpractice insurance to manage the legal liability due to the audit risk.
Audit risk exposes auditors to legal liability and penalties if they provide an unqualified opinion on financial statements that include a substantial misrepresentation that breaches laws or regulations. For example, Amazon was recently penalized $886 million for suspected GDPR violations.
Understanding Material Misstatements
Material misstatements arise in two forms. One is a fraud, and the other is due to an internal error. When the company's internal audit team intentionally issued the wrong financial statement to cover their fraudulent act, it is considered fraudulent financial reporting.
When the company fails to follow the accounting standard , primarily due to the carelessness of the management, it leads to errors while maintaining the financial statements. The negligence of the company's internal team caused this error. To reduce Audit risk, Auditing firms must apply appropriate audit procedures in many ways.
Audit Risk Types
The types of Audit risk are Inherent Risk, Control risk and detection risk. The inherent and controlled Risk together is called risks of Material misstatements. A balanced audit risk model is comprised of all three audit risks. By balancing it, an auditor can determine how comprehensive the audit work is.
1. Inherent Risk
Inherent Risk is the possibility of material misstatements on the client's financial statement. The incorrect information may be an error or omission in a financial statement, primarily due to a factor other than an error missed to correct by the internal audit team.
The inherent Risk occurs when the financial transactions are complex and have a complicated company's business model. This Risk is a worst-case scenario only when the internal team fails to find the error. The companies must have an internal audit team with high financial qualifications to reduce the occurrence of inherent Risk.
2. Control risk
The control risk is when the client's internal audit department fails to detect the potential material misstatement. The client's internal audit team or internal controls use accounting and auditing processes in their financial department to reduce the control risk.
The internal audit department uses the internal auditing processes the company's finance department insists on. These processes ensure the correct financial reporting, reducing miscalculations and errors. The internal team assists clients in adhering to rules and regulations and guards against employee fraud and asset theft. They help to maintain efficiency by identifying problems and correcting the errors before they are detected in an external audit firm.
3. Detection risk
The detection risk is that the Auditor fails to detect the existing material misstatement in the client's financial statements. These material misstatements may be due to either fraud or error. Auditors use audit processes to find these inaccuracies. The detection risk can be avoided with correct audit procedures.
The detection risk presence is unavoidable, and Auditor's goal must be to reduce the Risk to a greater extent. The auditors should do the various procedures to limit the detection risk and maintain it to an acceptable level in overall performance.
Risk Assessments Procedure
A risk assessment identifies and evaluates risks to use that information to guide the audit procedures required to justify the amounts stated in the financial statements.
A risk serves as the foundation for the audit plan in a risk assessment audit approach. However, the audit plan is typically constructed from an audit universe consisting of departments or procedures, despite many audit departments believing they are risk-based.
An accurate risk-based audit approach begins with evaluating the most significant risks to management. All plan audits are created to address such risks and give senior management information.
Let us see the approaches to Risk Assessment by Auditors.
1. Quick Assurance
Rapid Assurance entails conducting all elements of a typical assurance engagement in a condensed period with a commitment to just one week of fieldwork to reduce audit exhaustion in processes where documentation is vital. Typically, Rapid Assurance is broken down into three steps, each lasting 3-5 weeks:
- Planning and research for the auditor (1-2 Weeks)
- Fieldwork on-site (1 week)
- Finish testing and writing reports (1-2 weeks)
The auditor should possess good project management discipline and an in-depth understanding of the processes being audited due to the compressed period.
2. Real-Time Feedback
In Project Assurance, the auditor assesses the project team's governance, risk management, and control ability to immediately recognize and address project-related hazards. They also assume the facilitator position by encouraging the discussion of risk and control throughout a project.
A subject matter expert or guest auditor who can help spot hazards would be an excellent choice to execute a Project Assurance method, as would an auditor with past expertise in project or program execution.
3. Facilitated Self-Assessment
Using this workshop-style method, a department can review and commit to enhancing governance, risk management, and internal controls for a process or function. After all, someone is more motivated to solve a problem if they are part of its identification.
An auditor must be adept at facilitating small groups and flexible to change course midstream. A department assists in identifying and committing to improving its response to the particular issues encountered with the support of an external mentality and the capacity to encourage effective risk management and control behaviors.
4. Framing Assurance
A method based on maturity models enables auditors and audit clients to evaluate a process's efficacy while identifying the skills required to enhance the process to achieve goals. Both options are Capability Maturity Model Integration (CMMI) or creating customized models.
The auditor must feel at ease describing standard maturity models, like CMMI, and their technique for developing a unique model.
5. Data Analytics
Audit engagements can include data analysis tools to deliver deeper insights, improved risk management, and operational efficiency.
Data analytics will be more accessible if database administrators and reporting teams work together. The ideal auditor will be able to create scripts and be analytical, technical, and logical in their thinking. It would be best not to let a lack of technical expertise keep you from using data analytics.
Risk Audit and Assessment Services
With the proper risk audit and risk assessment procedures , the Auditors can improve their performances and provide good results to the clients. The Auditor's correct mindset to tackle risks and using their collection of risk-based approaches make it possible to have accurate results and a positive impact on their organization.
In case you are concerned about risks in your audit statement, you can always reach out to us! BMS Auditing is a global audit firm that provides risk audit and assessment services to businesses around the world. We conduct a comprehensive review of the business's operations, financial statements, and internal controls. Based on the findings of the review, BMS Auditing creates a risk assessment report that outlines the identified risks and how to improve its internal controls and risk management processes.
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