Responsibility For Identified Risk

Question 1

Responsibility

Answer 1

Auditor’s Responsibilities for Identified Risks

For each identified risk of material misstatement at the assertion level, the auditor must:

Assess Likelihood and Magnitude
1. Consider inherent risk factors affecting assertion susceptibility.
2. Evaluate how financial statement-level risks impact inherent risks of assertion-level .

Determine Significant Risks
1. Identify risks with high likelihood and/or magnitude.
2. Recognize that even one high factor (likelihood or magnitude) can classify a risk as significant.

Significant Risk Definition
A significant risk is an identified risk of material misstatement with an inherent risk assessment near the upper end of the inherent risk spectrum.

Next Steps
1. Determine if substantive procedures alone are sufficient for assertion-level risks.
2. Plan audit procedures to address significant risks and obtain sufficient appropriate audit evidence.Let’s break down the requirements:

1. Assess the likelihood and magnitude of material misstatement: The auditor must evaluate the probability (likelihood) and potential impact (magnitude) of a material misstatement occurring at the assertion level.

Example: Suppose we’re auditing a company’s accounts receivable assertion. We assess the likelihood of material misstatement as 40% (0.4) and the magnitude as $200,000.

Likelihood (L) = 0.4
Magnitude (M) = $200,000

1. Consider inherent risk factors: The auditor must evaluate how inherent risk factors affect the susceptibility of relevant assertions to misstatement. Inherent risk factors include complexity, industry, and nature of the business.

Example: The company’s accounts receivable process is complex, with multiple stages and approvals. This increases the inherent risk of material misstatement.

Inherent Risk Factor (IRF) = 0.6 (high complexity)

1. Consider risk of material misstatement at the financial statement level: The auditor must evaluate how the risk of material misstatement at the financial statement level affects the assessment of inherent risk for the risks of material misstatement at the assertion level.

Example: The company’s financial statements have a high risk of material misstatement due to aggressive revenue recognition practices. This increases the inherent risk of material misstatement at the accounts receivable assertion level.

Risk of Material Misstatement at Financial Statement Level (RMMFSL) = 0.7 (high risk)

1. Determine significant risks: The auditor must evaluate whether identified risks of material misstatement are significant risks. A significant risk is an identified risk of material misstatement for which the assessment of inherent risk is close to the upper end of the spectrum of inherent risks.

Example: Using the likelihood, magnitude, inherent risk factor, and risk of material misstatement at the financial statement level, we calculate the inherent risk:

Inherent Risk (IR) = L x M x IRF x RMMFSL
= 0.4 x $200,000 x 0.6 x 0.7
= $33,600

Since the inherent risk is close to the upper end of the spectrum of inherent risks (e.g., $50,000), we determine that this is a significant risk.

1. Evaluate substantive procedures: The auditor must evaluate whether substantive procedures alone cannot provide sufficient appropriate audit evidence for any of the risks of material misstatements at the assertion level.

Example: Due to the significant risk identified, we determine that substantive procedures alone are insufficient to provide appropriate audit evidence. We will need to perform additional procedures, such as tests of controls or other substantive procedures, to address the risk.

Remember, it’s the combination of likelihood and magnitude that determines where inherent risk is assessed on the spectrum of inherent risk. Even if one of these factors is high, it can still be considered a significant risk.