CHAPTER 7 INHERENT RISK ASSESSMENT AND MATERIALITY 1
INHERENT RISK (IR) Defined: Susceptibility of account balance or class of transactions to material misstatement, given inherent and environmental characteristics, without regard to internal control structure (AUS 402.09/ISA 400.04). Auditor required to assess IR at financial report level for audit plan, with assessment related to assertions at account balance or class of transactions level when developing audit program. 2
FACTORS AFFECTING IR AT FINANCIAL REPORT LEVEL Integrity of management Management experience, knowledge and changes during the period Unusual pressure on management Nature of entity s business Factors affecting the industry 3
INHERENT RISK AND COMPUTER INFORMATION SYSTEMS (CIS) As CIS risks can be pervasive to the entity, factors affecting overall IR associated with CIS are: Significant changes in CIS Insufficient CIS skills and resources Lack of entity support and focus High dependence on CIS Reliance on outsourced CIS Reliability and complexity of CIS 4
INHERENT RISK ASSESSMENT AT ACCOUNT BALANCE AND CLASS OF TRANSACTIONS LEVEL Considerations include: Accounts likely to require adjustment Complexity of underlying transactions Judgment involved in determining account balance Susceptibility of assets to loss or misappropriation Occurrence of unusual and complex transactions, particularly at or near year-end transactions not subject to ordinary processing 5
EFFECT OF INHERENT RISK ON AN ACCOUNT BALANCE ASSERTION Figure 7.1 Effect of inherent risk on an account balance assertion (p. 290) 6
CONSIDERATION OF FRAUD AT PLANNING STAGE At planning stage, auditor must consider the risk that misstatements from fraud or error will not be detected. It is easier to miss material misstatements resulting from fraud because fraud involves acts designed to conceal it. 7
AUDIT PROCEDURES FOR FRAUD AT PLANNING STAGE Auditor will use their experience, knowledge and training to determine whether fraud could occur. Auditor needs thorough understanding of client s business in order to identify opportunities for perpetration of fraud. Auditor will need to consider: Business environment Internal control structure 8
RISK AT RED FLAG INDICATORS OF FRAUD These are listed in Table 7.1 (p. 292) and are grouped under: Management Unusual pressures within an entity Market pressures Unusual transactions Unsatisfactory records CIS environment 9
CONSIDERING EARNINGS MANAGEMENT INCENTIVES Earnings management occurs when judgment in financial reporting and in structuring transactions is used to alter financial reports to influence perceptions of stakeholders of outcomes dependent on reported accounting numbers. Earnings management involves those responsible for preparing the financial report such as the Chief Financial Officer (CFO) and Chief Executive Officer (CEO). Incentives to manage earnings can be either behavioural or market-based. 10
BROAD CATEGORIES OF EARNINGS MANAGEMENT International violations of accounting standards and other reporting requirements that are individually immaterial Inappropriate revenue recognition Big bath charges under the guise of restructuring Improper accruals and estimation of liabilities in good times 11
CONSIDERING ILLEGAL ACTS AUS 218 provides guidance on auditor s consideration of illegal acts (noncompliance with laws and regulations): Must understand the legal and regulatory framework applicable to the entity and industry Audit normally does not include procedures designed specifically to detect illegal acts Auditor must recognise circumstances requiring special attention (e.g. debenture deed requires a specific current ratio be maintained) and consider these in preparation of audit programs 12
RELATED PARTIES The auditor must identify all related parties when planning the audit because: The existence of related parties or related-party transactions can affect the financial information. E.g. the accounting standards require the disclosure of information relating to related parties. The reliability of audit evidence is a function of the source of that evidence. Therefore, evidence from related parties and transactions with those parties need to be more carefully evaluated. The initiation of a related-party transaction might be motivated by other than ordinary business conditions, such as fraud. 13
PRELIMINARY ASSESSMENT OF GOING CONCERN BASIS I Defined: Entity expected to pay debts as and when they fall due, and continue to operate without any intention necessarily to liquidate or otherwise wind up operations. (AUS 708.03/ISA 570.03) Auditor required by standards to assess going concern at planning stage. Imminent business failure might have an effect on appropriateness of presentation of financial report or might motivate management misrepresentations. 14
PRELIMINARY ASSESSMENT OF GOING CONCERN BASIS II Early identification helps focus audit effort on appropriate assertions in financial report, and permits early communication with management. Auditor focuses primarily on anticipated events during the relevant period, approximately 12 months from date of current audit report to expected date of next audit report. 15
EXAMPLES OF INDICATIONS OF GOING CONCERN PROBLEMS Operating indicators include: Lack of strategic direction Concentration of risk in few products Loss of major market Financial indicators include: High gearing, debt/equity ratio Adverse movements in key ratios, falls in profitability, current, cash flow ratios Inability to pay creditors [See Table 7.2 (p. 298)] 16
EXAMPLES OF MITIGATING FACTORS Auditor should consider mitigating factors: Asset factors sale of assets, with delayed replacement Debt factors unused lines of credit, ability to renew or extend existing loans Cost factors ability to reduce costs Equity factors additional contributions from owners, subsidiaries or associates [See Table 7.3 (p.299)] 17
MATERIALITY Defined: information which if misstated, omitted, or not disclosed separately in a financial report may adversely affect either user decisions or the discharge of accountability by management. (AUS 306.03/ISA 320.03) Auditor uses materiality to: Evaluate presentation of financial data Determine nature, timing and extent of audit procedures 18
QUANTITATIVE GUIDELINES MATERIALITY Material 10% of appropriate base amount Immaterial 5% of appropriate base amount Judgment 5-10% of appropriate base amount Base amount for statement of financial position items equity, or the appropriate asset or liability class total Base amount for statement of financial performance items net profit or loss and appropriate revenue and expense amount, for year or averaged over a number of years 19
RULES OF THUMB FOR PLANNING MATERIALITY Range of percentages Common bases applied to base Relative advantages Net profit 5 10 Relevance Total revenue 0.5 1 Stability Total assets 0.5 1 Predictability and stability Equity 1 2 Stability Table 7.4 Rules of thumb for planning materiality (p. 303) 20
FINANCIAL INFORMATION USED AS BASE Can be taken from: Financial report to be audited (if available); Annualised interim financial information; or Previous period s financial report. 21
ALLOCATION OF MATERIALITY TO ACCOUNT BALANCES AND CLASSES OF TRANSACTIONS Auditor needs to allocate planning material to account balances and classes of transactions for audit testing. (Auditing standards are silent on this issue.) No required or optimal method, but auditor should consider: Dollar value of account Expectation of error 22
RELATIONSHIP BETWEEN MATERIALITY AND AUDIT RISK There is an inverse relationship between audit risk and materiality. Auditor sets a lower materiality threshold for accounts that have a higher audit risk. This means the auditor will need to collect more evidence for these accounts. 23