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In this chapter you will understand the auditor's requirements for client acceptance and continuance, understand the steps that are involved in the preliminary engagement activities, know what is required to establish an understanding with the client, know the types of information that are included in an engagement letter. | Chapter Three Risk Assessment and Materiality Audit Risk The risk that an auditor will issue an unmodified opinion on materially misstated financial statements. Financial statement level Individual account balance or class of transactions level Auditor’s Business Risk An auditor’s exposure to financial loss and damage to professional reputation. Client and third party lawsuits Negative publicity The Audit Risk Model Audit Risk = IR × CR × DR Inherent risk and control risk: Risk that material misstatements exist Non-sampling risk Sampling risk Detection risk: Risk that auditor will not detect misstatements Inappropriate audit procedure Fail to detect when using appropriate audit procedure Misinterpreting audit results Using the Audit Risk Model Set a planned level of audit risk such that an opinion can be issued on the financial statements. Assess inherent risk and control risk. Use the audit risk equation to solve for the appropriate level of detection risk: AR = IR × CR × DR DR = AR IR × CR Auditors use this level of detection risk to design audit procedures that will reduce audit risk to an acceptable level. Using the Audit Risk Model Using the Audit Risk Model Qualitative terms may also be used in the audit risk model. The Auditor’s Risk Assessment Process Auditors need to identify business risks and understand the potential misstatements that may result. Business risks include any external or internal factors, pressures, and forces that bear on the entity’s ability to survive and be profitable. The Auditor’s Risk Assessment Process Understanding the Entity and Its Environment Industry Factors Regulatory Environment Nature of the Entity Internal Control Objectives and Strategies Business Risks Financial Performance Auditor’s Risk Assessment Procedures Inquiries of Management and Others Analytical Procedures Observation and Inspection Identifying Business Risks Examples of conditions or events that indicate the existence of business risks: Significant | Chapter Three Risk Assessment and Materiality Audit Risk The risk that an auditor will issue an unmodified opinion on materially misstated financial statements. Financial statement level Individual account balance or class of transactions level Auditor’s Business Risk An auditor’s exposure to financial loss and damage to professional reputation. Client and third party lawsuits Negative publicity The Audit Risk Model Audit Risk = IR × CR × DR Inherent risk and control risk: Risk that material misstatements exist Non-sampling risk Sampling risk Detection risk: Risk that auditor will not detect misstatements Inappropriate audit procedure Fail to detect when using appropriate audit procedure Misinterpreting audit results Using the Audit Risk Model Set a planned level of audit risk such that an opinion can be issued on the financial statements. Assess inherent risk and control risk. Use the audit risk equation to solve for the appropriate level of detection risk: AR = IR × CR × DR
