Chapter 8

Assessing the Risk of Material Misstatement

 Concept Checks

P. 242

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. 257

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.

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Concept Check, P. 257 (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 and corrected 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

8-1 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).

8-2 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.

8-3 Auditing standards require the auditor to assess the risk of material
misstatement at the assertion level for classes of transactions, account balances,
and presentation and disclosure in order to determine the nature, timing, and
extent of further audit procedures. The risk of material misstatement at the
assertion level consists of two components: inherent risk and control risk.
Inherent risk represents the auditor’s assessment of the susceptibility of an
assertion to material misstatement before considering the effectiveness of the
client’s internal controls. Control risk represents 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. Inherent
risk and control risk are the client’s risks and they exist independent of the audit
of the financial statements.

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8-2
8-4 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 material misstatement for occurrence as
high.

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8-5 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.

8-6 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, including employees with different
levels of authority. Additionally, i nquiries 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 relevant 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.

8-7 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

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8-7 (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.

8-8 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.

8-9 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.

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8-10 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 related
account balances and disclosures are presumed to be significant risks in most
audits. If the auditor determines that the presumption is not applicable to a
particular audit engagement, the auditor must document this conclusion in the
working papers.

8-11 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.

8-12 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.

8-13 Significant non-routine transactions represent transactions that are

unusual, either due to size or nature, and that are infrequent in occurrence. The
terms of that transaction may be based on significant negotiations that include
various buy-back provisions and warranties that increase risks of material
misstatement related to revenue recognition and receivables collection. It is the
auditor’s responsibility to identify significant non-routine transactions which 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. Moreover, 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 of them being considered
to be significant risks.

8-14 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
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and not be prevented or detected and corrected on a timely basis by the client’s
internal controls.

8-15 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.

8-16 Audit assurance is the complement of acceptable audit risk. The concept
of acceptable audit risk can be more easily understood by thinking in terms of a
large number of audits.
Transactions between parent and subsidiary companies, and those
between management and the corporate entity, are examples of related party
transactions as defined by accounting standards. Because these transactions
do not occur between two independent parties dealing at “arm’s length,” a
greater likelihood exists that they may be misstated or inadequately disclosed,
causing an increase in inherent risk.

8-17 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.

8-18 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.

8-19 ‘Engagement risk’ is the risk that the auditor or audit firm will suffer harm
after the audit is finished, even though the audit report was cor rect.
Engagement risk is closely related to client business risk and therefore
acceptable audit risk. For example, if a client declares bankruptcy after an audit
is complete, the likelihood of a lawsuit against the CPA firm is reasonably high,
even if the quality of the audit was high. It is worth noting that auditors disagree
about whether engagement risk should be considered in planning the audit.
Opponents of modifying evidence for engagement risk contend that auditors do
not provide audit opinions for different levels of assurance and therefore should
not provide more or less assurance because of engagement risk. Proponents
contend that it is appropriate for auditors to accumulate additional evidence,
assign more experienced personnel, and review the audit more thoroughly on
audits where legal exposure is high or other potential adverse actions affecting
the auditor exist, as long as the assurance level is not decreased below a
reasonably high level when low engagement risk exists.

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8-20 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.

8-21 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.

8-22 Exact quantification of all components of the audit risk model is not
required to use the model in a meaningful way. An und erstanding 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.

8-23 The auditor should revise the components o f 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.

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8-24 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.

 Discussion Questions And Problems

8-25 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.

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8-26 a. PCAOB AS 2110 (paragraph .07) notes that the auditor, when
obtaining an understanding of the compa ny 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 AS 2110 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 AS 2110 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.

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8-26 (continued)
c. Paragraphs .49 through .53 of PCAOB AS 2110 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 AS 2110 note
that the determination is based on inherent risk, without regard to
the effect of controls. AS 2110 also 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 unusua l transactions

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8-26 (continued)

e. Paragraph .74 of PCAOB AS 2110 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
assessment, the auditor should revise the risk assessment and
modify planned audit procedures or perform additional procedures in
response to the revised risk assessments.

8-27 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 acqui red 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.

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8-27 (continued)

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,
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 accuracy,
valuation and allocation assertion). Risks of material
misstatements may also affect the presentation assertion 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 accuracy,
valuation and allocation assertion. Risks of material
misstatements may also affect the presentation assertion for
investments.

b. Given the significance of these rece nt 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.

8-28 a. Inherent risk is the susceptibility of an assertion to material

misstatement without considering control risk. A significant risk is an
inherent risk that requires special audit consideration. Business risk is
the risk that the client may not achieve its objectives. A business risk
may, but does not necessarily result in an inherent risk or significant
risk. For example, a decrease in demand for a company’s products
may increase inherent risk for realizable value of inventories.
Depending on the size of inventory and the significance of the risk,
this risk may be considered a significant risk.

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8-28 (continued)

b.
1. Not a significant risk – The increase in the age of accounts
receivable increases inherent risk for accounts receivable. Based
on the description, this does not appear to be a significant risk, but
could be depending on the significance of the amounts involved.
2. Significant risk – The significance of the transaction and its
unfamiliarity to the organization suggest it should be considered a
significant risk.
3. Significant risk – This appears to be a fraud risk related to revenue
recognition. All fraud risks are considered significant risks.
4. Not a significant risk – The industry competition is a business risk.
5. Significant risk – The potential impairment of significant amounts of
goodwill appears to be a significant risk.
6. Significant risk – The significant build-up of inventory and potential
for a write-down for obsolescence appears to be a significant risk.

c.
1. To address the significant risk related to contract accounting, the
audit firm should make sure that staff with experience auditing
contracts in-progress are assigned to the area and review the
results of testing more closely.
2. The significant risk due to potential revenue recognition fraud will
likely result in several changes in testing. The auditor will likely
want to expand revenue cutoff testing, and also increase tests for
sales returns after year-end. The auditor may increase the use of
accounts receivable confirmations, including confirmation of the
terms of sale.
3. The use of a valuation specialist will help address potential goodwill
impairment.
4. The auditor could address the significant risk for potential inventory
obsolescence by examining subsequent sales and selling prices of
inventory sold after year end.

8-29 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.

a. True. A CPA firm should attempt to use reasonable uniformity from

audit to audit when circumstances are similar. The only reasons
for having a different audit risk in these circumstances are the
lack of consistency within the firm, different audit risk
preferences for different auditors, and difficulties of measuring
audit risk.

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8-28 (continued)
b. True. Users who rely heavily upon the financial statements need
more reliable information than those who do not place heavy
reliance on the financial statements. To protect those users, the
auditor needs to be reasonably assured that the financial
statements are fairly stated. That is equivalent to stating that
acceptable audit risk is lower. Consistent with that conclusion, the
auditor is also likely to face greatest legal exposure in situations
where external users rely heavily upon the statements. Therefore,
the auditor should be more certain that the financial statements
are correctly stated.

c. True. The reasoning for c. is essentially the same as for b.

d. True. The audit opinion issued by different auditors conveys the

same meaning regardless of who signs the report. Users cannot
be expected to evaluate whether different auditors take different
risk levels. Therefore, for a given set of circumstances, every CPA
firm should attempt to obtain approximately the same audit risk.

8-30 a. Low, medium, and high for the four risks and planned evidence
have meaning only in comparison to each other. For example,
an acceptable audit risk that is high means the auditor is willing
to accept more risk than in a situation where there is medium risk
without specifying the precise percentage of risk. The same is true
for the other three risk factors and planned evidence.

b. 1 2 3 4 5 6

Acceptable Audit Risk M L H H H L

IR x CR M M L M M H

PDR = AAR / (IR x CR) M L H M M L

Planned Evidence M H L M M H

L = low, M = medium, H = high

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8-30 (continued)
c.
EFFECT ON
CHANGE IN FACTOR EFFECT ON PDR EVIDENCE

(1) Decrease AAR Decrease Increase

(2) Decrease in CR Increase Decrease
(3) Decrease in PDR NA Increase
(4) Decrease in IR Increase Decrease
(5) Decrease in IR, No effect No effect
increase in CR of
same amount

8-31 a. 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 unqualified opinion has been issued. This is the risk that the
auditor will give an incorrect audit opinion.
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. This risk relates to the auditor’s expectation of misstatements in
the financial statements, ignoring internal control.
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. This risk is related to the effecti veness of a client’s
internal controls.
Planned detection risk A measure of the risk that audit evidence for an audit
objective will fail to detect misstatements exceeding performance materiality,
should such misstatements exist. This risk is determined by using the other three
factors in the risk model using the formula PDR = AAR / (IR x CR).
b.

Risk of Material Misstatements

Balance- Acceptable Inherent Control Planned
Related Audit Audit Risk Risk Risk Detection
Objectives Risk
Existence Medium Medium Medium Medium
Completeness Medium Low Medium Medium
Accuracy Low High Medium Low
Classification Medium Low Low High
Cut-off Medium Medium Low Medium
Detail tie-in Low Medium Low Low/Medium
Realizable Low High Medium Low
value
Rights and Medium Medium Low Medium
obligations

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8-16
c. The accuracy and realizable value audit objectives require the greatest
amount of evidence in order to reduce detection risk to a low level. The
classification audit objective requires the least amount of evidence as planned
detection risk is at a high level.
d. John may increase his assessment of control risk in the existence,
completeness and cutoff audit objectives, which would result in a decrease in
acceptable audit risk and a decrease in planned detection risk. If Mark decides it
is appropriate to lower planned detection risk, he will increase the amount of
audit evidence gathered.

8-32

RISK FACTOR RELATED AUDIT RISK MODEL COMPONENT

1. Acceptable audit risk
2. Control risk
3. Acceptable audit risk
4. Inherent risk
5. Planned detection risk
6. Acceptable audit risk
7. Inherent risk
8. Inherent risk
9. Planned detection risk
10. Control risk

8-33

CONTROL INHERENT ACCEPTABLE PLANNED

RISK RISK AUDIT RISK EVIDENCE

a. N N D I
b. I N N I
c. I or N I N I
d. N I N I
e. N N I D
f. N N I D
g. I I N I
h. D D N or I D
i. I I D I
j. I N or I D I

8-34 a. Sort the invoice file by invoice amount. The five largest
transactions are listed below.

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 Invoice
Number Amount
139179 $12,571,043.85
139607 $11,385,059.36
139619 $11,117,093.48
139039 $9,893,615.34
139374 $8,577,691.28

These transactions are much larger than other sales transactions

(the next largest sale is $2,362,365.32). All five sales occurred in
the last two months of the year, were to the same customer, and
involved the same product number which has a different for mat (it
includes a hyphen) than standard product numbers.
It is an auditor judgment, but these transactions would
likely cause the auditor to increase inherent risk. Because of the
combined amounts involved, they would also likely be regarded as
a significant risk.
b. In addition to the transactions indicated in part a., the following
transactions involve sales to potentially invalid customer numbers.

Invoice Customer
Number Number Amount
139549 3975 $395,353.71
136856 3495 $133,392.76
138839 3294 $103,217.38
135863 3254 $19,805.00
138595 3095 $413,484.52
136130 3095 $261,211.19
137909 3062 $15,663.40

All valid JA customer numbers start with the 1 as the first digit.
Because JA has a small number of customers, most students will
sort the file by customer number to identify these transactions. If a
larger number of customers were involved, it would be more
effective to use a VLOOKUP to identify customer numbers that are
not included in the Customer_Master file or use ACL or IDEA to
identify customer numbers.

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8-34 (continued)

To identify unusual product numbers, compare the product

numbers included in the Invoice file to those in the
Product_Master file using a VLOOKUP function. Navigate to the
Invoice tab and include a new column name (e.g. Products) in
column L. In cell L2, enter
=VLOOKUP(F2,Product_Master!$A$2:$F$12,1,FALSE). This will
add the product number to the cell, or return #N/A for any
instances where the product number is not included on the
Product_Master list. Copy the formula all the way down the
column. Highlight the worksheet, filter the data, and filter for
values where “Products” equals #N/A. This identifies the same 5
transactions listed in part a. for product SO-TRUALL1001, but no
additional concerns.
To identify unusual prices, sort the Invoice worksheet by
product number and by price to identify the range of prices. Most
ranges are reasonable, with the exception again of the 5
transactions identified in part a. and b. above.

c. $178,173,912.47.

Filter the table on customer number. Select Customer Number

1027 and then sum the amount column on the filtered file.
Alternatively, use a SUMIF function as follows:
=SUMIF(E2:E4013,1027,I2:I4013) to identify customer number
1027 in column E and return the sum of the amounts in column I.

Case

8-35
EFFECT ON THE AUDIT RISK
RISK OF MATERIAL MODEL
FACTOR MISSTATEMENT COMPONENT
1. The company’s stock is publicly Increases Acceptable audit
traded. risk
2. Henderson is a new client. Increases Inherent risk
3. Henderson operates in a regulated Increases Acceptable audit
industry, which increases risk
regulatory oversight and need for
compliance with regulations.
4. The company is more profitable Increases Acceptable audit
than competitors, but recent risk
growth has strained operations.

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8-35 (continued)
EFFECT ON THE AUDIT RISK
RISK OF MATERIAL MODEL
FACTOR MISSTATEMENT COMPONENT
5. The company has Increases Inherent risk
expanded its use of
derivatives and hedging
transactions.
6. Henderson has added Decreases Control risk
competent accounting
staff and has an internal
audit function with
direct reporting to the
audit committee.
7. The financial Increases Inherent risk
statements contain
several accounting
estimates that are
based on management
assumptions.
8. The company has Increases Control risk
experienced difficulty in
tracking property, plant,
and equipment.
9. Henderson acquired a Increases Inherent risk
regional electric
company.
10. The audit engagement Decreases Planned detection risk 1
staff have experience in
auditing energy and
public companies.
11. Partner review of key Decreases Planned detection risk.1
accounts will be
extensive.
1
The competency of the audit engagement staff and the thoroughness of the
partner’s review will lower the risk that material misstatements will not be
detected by the auditor, which results in a lower actual detection risk.

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Integrated Case Application

8-36
PINNACLE MANUFACTURING―PART II

a. Assessment of Acceptable Audit Risk:

External users’ reliance on financial statements:

1. The company is privately held, but there is a large amount
of debt; therefore, the financial statements will be used
fairly extensively. Also, management is considering
selling the Machine-Tech division, which has the potential
to result in extensive use of the statements by the buyers.
2. Item 4 in the planning phase indicates plans for additional
debt financing.

Likelihood of financial difficulties:

1. The solar power engine business revolves around
constantly changing technology, thus making it inherently
more risky than other businesses, with a better chance of
subsequent bankruptcy. Item 1 in the planning issues
raises a concern about the viability of the Solar-Electro
division, but not necessarily the entire company.
2. The conclusion in Part I of the case was that the likelihood
of financial failure is low, even considering the issue with
Solar-Electro.
3. Item 3 in the planning phase indicates there is a debt
covenant requiring a current ratio above 2.0 and a debt-to-
equity ratio below 1.0. The current ratio has fallen below
2.0. This could result in the loan being called unless a
waiver of the loan covenant is granted.

Management integrity:
No major issue exists that would cause the auditor to question
management integrity, but the auditor should have done extensive
client acceptance procedures before accepting the client. It is
possible that Item 5 in the planning phase, turnover of internal
audit personnel, could be intentional and increases the risk of
fraudulent financial reporting.

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8-36 (continued)
Overall Assessment of Acceptable Audit Risk:
Acceptable audit risk is likely to be medium to low because of the
factors listed previously, especially the planned increase in
financing and the potential violation of the debt covenant
agreement. Some might prefer an even lower acceptable risk
because it is a first-year audit.

b. Inherent risks are addressed by examini ng each of the 8 items in

the planning phase.

1. No Inherent Risk

2. Financial Statement Level Risk: The reliance on one

supplier that is in financial difficulty indicates the
potential for disruption of Pinnacle operations.

3. Financial Statement Level Risk: In addition to affecting

acceptable audit risk, the auditor should be concerned
about the risk of fraudulent financial reporting due to the
incentive to make certain that all debt covenants have been
met.

4. No Inherent Risk: The need to raise additional financing

was noted as a factor in the evaluation of acceptable
audit risk in part a.

5. Financial Statement Level Inherent Risk: Although this

does not directly affect inherent risk, it is possible that
turnover of internal audit personnel could be intentional
and increases the risk of fraudulent financial reporting. The
turnover may also affect the auditor’s assessment of control
risk.

6. Assertion Level Inherent Risk: The primary concern is

the possibility of obsolete inventory, which affects the
valuation of inventory at the lower of cost or market.

7. Assertion Level Inherent Risk: There is a potential

related party transaction, which could affect the valuation of
the transaction and may require disclosure as a related
party transaction. The primary balance sheet account
affected is manufacturing equipment.

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8-36 (continued)
8. Assertion Level Inherent Risk: An ongoing dispute with
the Internal Revenue Service may require an adjustment to
income tax liability or a disclosure in footnotes for a
contingency, depending on the status of the dispute. The
primary balance sheet account affected is income taxes
payable.

c. Item #2 involving the potential bankruptcy of a major supplier is

likely a significant risk. The auditor would evaluate the potential
disruption to inventory purchases and production should this
vendor go bankrupt.
The potential violation of the debt covenant in item #3,
combined with the turnover in the internal audit department in item
#5 may cause the auditor to increase the assessment of the risk of
fraud. This could be addressed by adding more experienced audit
personnel, increasing the level of review of the audit work, and
adding unpredictability to the audit procedures to identify potential
fraudulent activities.
Although items #6, 7, and 8 represent inherent risks, they
do not appear sufficiently material to be judged as significant risks.

d. Because financial statement level risks of fraudulent financial

reporting were identified, the auditor is likely to expand the extent
of cutoff testing and the search for unrecorded accounts payable.
The auditor would also likely carefully review the amounts
and disclosures related to the potential related party vendor
identified in planning item # 7.

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