Managing the risk of material misstatement in the purchasing process is critical. Identify two (2) different industries and analyze how these risks differ from one industry to the other. Also, identify internal controls that could help to keep these misstatements to a minimum
Introduction
.01 This standard establishes requirements regarding the process of identifying and assessing risks of material misstatement of the financial statements.
.02 Paragraphs .04-.58 of this standard discuss the auditor's responsibilities for performing risk assessment procedures. Paragraphs .59-.73 of this standard discuss identifying and assessing the risks of material misstatement using information obtained from performing risk assessment procedures.
Objective
.03 The objective of the auditor is to identify and appropriately assess the risks of material misstatement, thereby providing a basis for designing and implementing responses to the risks of material misstatement.
Performing Risk Assessment Procedures
.04 The auditor should perform risk assessment procedures that are sufficient to provide a reasonable basis for identifying and assessing the risks of material misstatement, whether due to error or fraud, and designing further audit procedures.
.05 Risks of material misstatement can arise from a variety of sources, including external factors, such as conditions in the company's industry and environment, and company-specific factors, such as the nature of the company, its activities, and internal control over financial reporting. For example, external or company-specific factors can affect the judgments involved in determining accounting estimates or create pressures to manipulate the financial statements to achieve certain financial targets. Also, risks of material misstatement may relate to, e.g., personnel who lack the necessary financial reporting competencies, information systems that fail to accurately capture business transactions, or financial reporting processes that are not adequately aligned with the requirements in the applicable financial reporting framework. Thus, the audit procedures that are necessary to identify and appropriately assess the risks of material misstatement include consideration of both external factors and company-specific factors. This standard discusses the following risk assessment procedures:
Inquiring of the audit committee, management, and others within the company about the risks of material misstatement (paragraphs .54-.58).
Note: This standard describes an approach to identifying and assessing risks of material misstatement that begins at the financial statement level and with the auditor's overall understanding of the company and its environment and works down to the significant accounts and disclosures and their relevant assertions.
.06 In an integrated audit, the risks of material misstatement of the financial statements are the same for both the audit of internal control over financial reporting and the audit of financial statements. The auditor's risk assessment procedures should apply to both the audit of internal control over financial reporting and the audit of financial statements.
Obtaining an Understanding of the Company and Its Environment
.07 The auditor should obtain an understanding of the company and its environment ("understanding of the company") to understand the events, conditions, and company activities that might reasonably be expected to have a significant effect on the risks of material misstatement. Obtaining an understanding of the company includes understanding:
.08 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.
Industry, Regulatory, and Other External Factors
.09 Obtaining an understanding of relevant industry, regulatory, and other external factors encompasses industry factors, including the competitive environment and technological developments; the regulatory environment, including the applicable financial reporting framework and the legal and political environment; and external factors, including general economic conditions.
Nature of the Company
.10 Obtaining an understanding of the nature of the company includes understanding:
The company's operating characteristics, including its size and complexity;
Note: The size and complexity of a company might affect the risks of misstatement and how the company addresses those risks.
.10A To assist in obtaining information for identifying and assessing risks of material misstatement of the financial statements associated with a company's financial relationships and transactions with its executive officers (e.g., executive compensation, including perquisites, and any other arrangements), the auditor should perform procedures to obtain an understanding of the company's financial relationships and transactions with its executive officers. The procedures should be designed to identify risks of material misstatement and should include, but not be limited to (1) reading the employment and compensation contracts between the company and its executive officers and (2) reading the proxy statements and other relevant company filings with the Securities and Exchange Commission and other regulatory agencies that relate to the company's financial relationships and transactions with its executive officers.
.11 As part of obtaining an understanding of the company as required by paragraph .07, the auditor should consider performing the following procedures and the extent to which the procedures should be performed:
Selection and Application of Accounting Principles, Including Related Disclosures
.12 As part of obtaining an understanding of the company's selection and application of accounting principles, including related disclosures, the auditor should evaluate whether the company's selection and application of accounting principles are appropriate for its business and consistent with the applicable financial reporting framework and accounting principles used in the relevant industry. Also, to identify and assess risks of material misstatement related to omitted, incomplete, or inaccurate disclosures, the auditor should develop expectations about the disclosures that are necessary for the company's financial statements to be presented fairly in conformity with the applicable financial reporting framework.
.13 The following matters, if present, are relevant to the necessary understanding of the company's selection and application of accounting principles, including related disclosures:
Company Objectives, Strategies, and Related Business Risks
.14 The purpose of obtaining an understanding of the company's objectives, strategies, and related business risks is to identify business risks that could reasonably be expected to result in material misstatement of the financial statements.
Note: Some relevant business risks might be identified through other risk assessment procedures, such as obtaining an understanding of the nature of the company and understanding industry, regulatory, and other external factors.
.15 The following are examples of situations in which business risks might result in material misstatement of the financial statements:
Note: Business risks could affect risks of material misstatement at
the financial statement level, which would affect many accounts and
disclosures in the financial statements. For example, a company's
loss of financing or declining conditions affecting the company's
industry could affect its ability to settle its obligations when
due. This, in turn, could affect the risks of material misstatement
related to, e.g., the classification of long-term
liabilities or valuation of long-term assets, or it could result in
substantial doubt about the company's ability to continue as a
going concern. Other business risks could affect the risks of
material misstatement for particular accounts, disclosures, or
assertions. For example, an unsuccessful new product or service or
failed business expansion might affect the risks of material
misstatement related to the valuation of inventory and other
related assets.
Company Performance Measures
.16 The purpose of obtaining an understanding of the company's performance measures is to identify performance measures, whether external or internal, that affect the risks of material misstatement.
.17 The following are examples of performance measures that might affect the risks of material misstatement:
Note: The first two examples represent performance measures that
can affect the risks of material misstatement by creating
incentives or pressures for management of the company to manipulate
certain accounts or disclosures to achieve certain performance
targets (or conceal a failure to achieve those targets). The third
example represents performance measures that management might use
to monitor risks affecting the financial statements.
Note: Smaller companies might have less formal processes to measure and review financial performance. In such cases, the auditor might identify relevant performance measures by considering the information that the company uses to manage the business.
Obtaining an Understanding of Internal Control Over Financial Reporting
.18 The auditor should obtain a sufficient understanding of each component of internal control over financial reporting ("understanding of internal control") to (a) identify the types of potential misstatements, (b) assess the factors that affect the risks of material misstatement, and (c) design further audit procedures.
.19 The nature, timing, and extent of procedures that are necessary to obtain an understanding of internal control depend on the size and complexity of the company; the auditor's existing knowledge of the company's internal control over financial reporting; the nature of the company's controls, including the company's use of IT; the nature and extent of changes in systems and operations; and the nature of the company's documentation of its internal control over financial reporting.
Note: The auditor also might obtain an understanding of certain controls that are not part of internal control over financial reporting, e.g., controls over the completeness and accuracy of operating or other non financial information used as audit evidence.
.20 Obtaining an understanding of internal control includes evaluating the design of controls that are relevant to the audit and determining whether the controls have been implemented.
Note: Procedures the auditor performs to obtain evidence about design effectiveness include inquiry of appropriate personnel, observation of the company's operations, and inspection of relevant documentation. Walk through, as described in paragraphs .37-.38, that include these procedures ordinarily are sufficient to evaluate design effectiveness.
Note: Determining whether a control has been implemented means determining whether the control exists and whether the company is using it. The procedures to determine whether a control has been implemented may be performed in connection with the evaluation of its design. Procedures performed to determine whether a control has been implemented include inquiry of appropriate personnel, in combination with observation of the application of controls or inspection of documentation. Walk through, as described in paragraphs .37-.38, that include these procedures ordinarily are sufficient to determine whether a control has been implemented.
.21 Internal control over financial reporting can be described as consisting of the following components:
.22 Management might use an internal control framework with components that differ from the components identified in the preceding paragraph when establishing and maintaining the company's internal control over financial reporting. In evaluating the design of controls and determining whether they have been implemented in an audit of financial statements only, the auditor may use the framework used by management or another suitable, recognized framework. For integrated audits, AS 2201, states, "The auditor should use the same suitable, recognized control framework to perform his or her audit of internal control over financial reporting as management uses for its annual evaluation of the effectiveness of the company's internal control over financial reporting." If the auditor uses a suitable, recognized internal control framework with components that differ from those listed in the preceding paragraph, the auditor should adapt the requirements in paragraphs .23-.36 of this standard to conform to the components in the framework used.
Control Environment
.23 The auditor should obtain an understanding of the company's control environment, including the policies and actions of management, the board, and the audit committee concerning the company's control environment.
.24 Obtaining an understanding of the control environment includes assessing:
Whether the board or audit committee understands and exercises oversight responsibility over financial reporting and internal control.
Note: In an audit of financial statements only, this assessment may be based on the evidence obtained in understanding the control environment, in accordance with paragraph .23, and the other relevant knowledge possessed by the auditor. In an integrated audit of financial statements and internal control over financial reporting, AS 2201 describes the auditor's responsibility for evaluating the control environment.
.25 If the auditor identifies a control deficiency in the company's control environment, the auditor should evaluate the extent to which this control deficiency is indicative of a fraud risk factor, as discussed in paragraphs .65-.66 of this standard.
The Company's Risk Assessment Process
.26 The auditor should obtain an understanding of management's process for:
.27 Obtaining an understanding of the company's risk assessment process includes obtaining an understanding of the risks of material misstatement identified and assessed by management and the actions taken to address those risks.
Information and Communication
.28 Information System Relevant to Financial Reporting. The auditor should obtain an understanding of the information system, including the related business processes, relevant to financial reporting, including:
The period-end financial reporting process.
Note: Appendix B discusses additional considerations regarding manual and automated systems and controls.
.29 The auditor also should obtain an understanding of how IT affects the company's flow of transactions. (See Appendix B.)
Note: The identification of risks and controls within IT is not a separate evaluation. Instead, it is an integral part of the approach used to identify significant accounts and disclosures and their relevant assertions and, when applicable, to select the controls to test, as well as to assess risk and allocate audit effort.
.30 A company's business processes are the activities designed to:
.31 Obtaining an understanding of the company's business processes assists the auditor in obtaining an understanding of how transactions are initiated, authorized, processed, and recorded.
.32 A company's period-end financial reporting process, as referred to in paragraph .28e, includes the following:
.33 Communication. The auditor should obtain an understanding of how the company communicates financial reporting roles and responsibilities and significant matters relating to financial reporting to relevant company personnel and others, including:
Control Activities
.34 The auditor should obtain an understanding of control activities that is sufficient to assess the factors that affect the risks of material misstatement and to design further audit procedures, as described in paragraph .18 of this standard. As the auditor obtains an understanding of the other components of internal control over financial reporting, he or she is also likely to obtain knowledge about some control activities. The auditor should use his or her knowledge about the presence or absence of control activities obtained from the understanding of the other components of internal control over financial reporting in determining the extent to which it is necessary to devote additional attention to obtaining an understanding of control activities to assess the factors that affect the risks of material misstatement and to design further audit procedures.
Note: A broader understanding of control activities is needed for relevant assertions for which the auditor plans to rely on controls. Also, in the audit of internal control over financial reporting, the auditor's understanding of control activities encompasses a broader range of accounts and disclosures than what is normally obtained in a financial statement audit.
Monitoring of Controls
.35 The auditor should obtain an understanding of the major types of activities that the company uses to monitor the effectiveness of its internal control over financial reporting and how the company initiates corrective actions related to its controls.
.36 An understanding of the company's monitoring activities includes understanding the source of the information used in the monitoring activities.
Performing Walk through
.37 As discussed in paragraph .20, the auditor may perform walk through as part of obtaining an understanding of internal control over financial reporting. For example, the auditor may perform walk through in connection with understanding the flow of transactions in the information system relevant to financial reporting, evaluating the design of controls relevant to the audit, and determining whether those controls have been implemented. In performing a walk through, the auditor follows a transaction from origination through the company's processes, including information systems, until it is reflected in the company's financial records, using the same documents and IT that company personnel use. Walk through procedures usually include a combination of inquiry, observation, inspection of relevant documentation, and re-performance of controls.
Note: For integrated audits, AS 2201 establishes certain objectives that the auditor should achieve to further understand likely sources of potential misstatements and as part of selecting the controls to test. AS 2201 states that performing walk through will frequently be the most effective way of achieving those objectives.
.38 In performing a walk through, at the points at which important processing procedures occur, the auditor questions the company's personnel about their understanding of what is required by the company's prescribed procedures and controls. These probing questions, combined with the other walk through procedures, allow the auditor to gain a sufficient understanding of the process and to be able to identify important points at which a necessary control is missing or not designed effectively. Additionally, probing questions that go beyond a narrow focus on the single transaction used as the basis for the walk through allow the auditor to gain an understanding of the different types of significant transactions handled by the process.
Relationship of Understanding of Internal Control to Tests of Controls
.39 The objective of obtaining an understanding of internal control, as discussed in paragraph .18 of this standard, is different from testing controls for the purpose of assessing control risk or for the purpose of expressing an opinion on internal control over financial reporting in the audit of internal control over financial reporting. The auditor may obtain an understanding of internal control concurrently with performing tests of controls if he or she obtains sufficient appropriate evidence to achieve the objectives of both procedures. Also, the auditor should take into account the evidence obtained from understanding internal control when assessing control risk and, in the audit of internal control over financial reporting, forming an opinion about the effectiveness of internal control over financial reporting.
.40 Relationship of Understanding of Internal Control to Evaluating Entity-Level Controls in an Audit of Internal Control Over Financial Reporting. AS 2201 states, "The auditor must test those entity-level controls that are important to the auditor's conclusion about whether the company has effective internal control over financial reporting." The procedures performed to obtain an understanding of certain components of internal control in accordance with this standard, e.g., the control environment, the company's risk assessment process, information and communication, and monitoring of controls, might provide evidence that is relevant to the auditor's evaluation of entity-level controls. The auditor should take into account the evidence obtained from understanding internal control when determining the nature, timing, and extent of procedures necessary to support the auditor's conclusions about the effectiveness of entity-level controls in the audit of internal control over financial reporting.
Considering Information from the Client Acceptance and Retention Evaluation, Audit Planning Activities, Past Audits, and Other Engagements
.41 Client Acceptance and Retention and Audit Planning Activities. The auditor should evaluate whether information obtained from the client acceptance and retention evaluation process or audit planning activities is relevant to identifying risks of material misstatement. Risks of material misstatement identified during those activities should be assessed as discussed beginning in paragraph .59 of this standard.
.42 Past Audits. In subsequent years, the auditor should incorporate knowledge obtained during past audits into the auditor's process for identifying risks of material misstatement, including when identifying significant ongoing matters that affect the risks of material misstatement or determining how changes in the company or its environment affect the risks of material misstatement, as discussed in paragraph .08 of this standard.
.43 If the auditor plans to limit the nature, timing, or extent of his or her risk assessment procedures by relying on information from past audits, the auditor should evaluate whether the prior years' information remains relevant and reliable.
.44 Other Engagements. When the auditor has performed a review of interim financial information in accordance with AS 4105, Reviews of Interim Financial Information, the auditor should evaluate whether information obtained during the review is relevant to identifying risks of material misstatement in the year-end audit.
.45 The auditor should obtain an understanding of the nature of the services that have been performed for the company by the auditor or affiliates of the firm and should take into account relevant information obtained from those engagements in identifying risks of material misstatement.
Performing Analytical Procedures
.46 The auditor should perform analytical procedures that are designed to:
.47 In applying analytical procedures as risk assessment procedures, the auditor should perform analytical procedures relating to revenue with the objective of identifying unusual or unexpected relationships involving revenue accounts that might indicate a material misstatement, including material misstatement due to fraud. Also, when the auditor has performed a review of interim financial information in accordance with AS 4105, he or she should take into account the analytical procedures applied in that review when designing and applying analytical procedures as risk assessment procedures.
.48 When performing an analytical procedure, the auditor should use his or her understanding of the company to develop expectations about plausible relationships among the data to be used in the procedure. When comparison of those expectations with relationships derived from recorded amounts yields unusual or unexpected results, the auditor should take into account those results in identifying the risks of material misstatement.
Note: Analytical procedures performed as risk assessment procedures often use data that is preliminary or data that is aggregated at a high level, and, in those instances, such analytical procedures are not designed with the level of precision necessary for substantive analytical procedures.
Conducting a Discussion among Engagement Team Members Regarding Risks of Material Misstatement
.49 The key engagement team members should 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 misstatement due to error or fraud.
Note: The key engagement team members should discuss the potential for material misstatement due to fraud either as part of the discussion regarding risks of material misstatement or in a separate discussion.
Note: As discussed in paragraph .67, the financial statements might be susceptible to misstatement through omission of required disclosures or presentation of inaccurate or incomplete disclosures.
.50 Key engagement team members include all engagement team members who have significant engagement responsibilities, including the engagement partner. The manner in which the discussion is conducted depends on the individuals involved and the circumstances of the engagement. For example, if the audit involves more than one location, there could be multiple discussions with team members in differing locations. The engagement partner or other key engagement team members should communicate the important matters from the discussion to engagement team members who are not involved in the discussion.
Note: If the audit is performed entirely by the engagement partner, that engagement partner, having personally conducted the planning of the audit, is responsible for evaluating the susceptibility of the company's financial statements to material misstatement.
.51 Communication among the engagement team members about significant matters affecting the risks of material misstatement should continue throughout the audit, including when conditions change.
Discussion of the Potential for Material Misstatement Due to Fraud
.52 The discussion among the key engagement team members about the potential for material misstatement due to fraud should occur with an attitude that includes a questioning mind, and the key engagement team members should set aside any prior beliefs they might have that management is honest and has integrity. The discussion among the key engagement team members should include:
.53 The auditor should emphasize the following matters to all engagement team members:
Inquiring of the Audit Committee, Management, and Others within the Company about the Risks of Material Misstatement
.54 The auditor should inquire of the audit committee, or equivalent (or its chair), management, the internal audit function, and others within the company who might reasonably be expected to have information that is important to the identification and assessment of risks of material misstatement.
Note: The auditor's inquiries about risks of material misstatement should include inquiries regarding fraud risks.
.55 The auditor should use his or her knowledge of the company and its environment, as well as information from other risk assessment procedures, to determine the nature of the inquiries about risks of material misstatement.
Inquiries Regarding Fraud Risks
.56 The auditor's inquiries regarding fraud risks should include the following:
.57 In addition to the inquiries outlined in the preceding paragraph, the auditor should inquire of others within the company about their views regarding fraud risks, including, in particular, whether they have knowledge of fraud, alleged fraud, or suspected fraud. The auditor should identify other individuals within the company to whom inquiries should be directed and determine the extent of such inquiries by considering whether others in the company might have additional knowledge about fraud, alleged fraud, or suspected fraud or might be able to corroborate fraud risks identified in discussions with management or the audit committee. Examples of other individuals within the company to whom inquiries might be directed include:
.58 When evaluating management's responses to inquiries about fraud risks and determining when it is necessary to corroborate management's responses, the auditor should take into account the fact that management is often in the best position to commit fraud. Also, the auditor should obtain evidence to address inconsistencies in responses to the inquiries.
Identifying and Assessing the Risks of Material Misstatement
.59 The auditor should identify and assess the risks of material misstatement at the financial statement level and the assertion level. In identifying and assessing risks of material misstatement, the auditor should:
Identify risks of misstatement using information obtained from performing risk assessment procedures (as discussed in paragraphs .04-.58) and considering the characteristics of the accounts and disclosures in the financial statements.
Note: Factors relevant to identifying fraud risks are discussed in paragraphs .65-.69 of this standard.
Evaluate the types of potential misstatements that could result from the identified risks and the accounts, disclosures, and assertions that could be affected.
Note: In identifying and assessing risks at the assertion level, the auditor should evaluate how risks at the financial statement level could affect risks of misstatement at the assertion level.
Assess the likelihood of misstatement, including the possibility of multiple misstatements, and the magnitude of potential misstatement to assess the possibility that the risk could result in material misstatement of the financial statements.
Note: In assessing the likelihood and magnitude of potential misstatement, the auditor may take into account the planned degree of reliance on controls selected to test.
Identify significant accounts and disclosures and their relevant assertions (paragraphs .60-.64 of this standard).
Note: The determination of whether an account or disclosure is significant or whether an assertion is a relevant assertion is based on inherent risk, without regard to the effect of controls.
Identifying Significant Accounts and Disclosures and Their Relevant Assertions
.60 To identify significant accounts and disclosures and their relevant assertions in accordance with paragraph .59e, the auditor should evaluate the qualitative and quantitative risk factors related to the financial statement line items and disclosures. Risk factors relevant to the identification of significant accounts and disclosures and their relevant assertions include:
.61 As part of identifying significant accounts and disclosures and their relevant assertions, the auditor also should determine the likely sources of potential misstatements that would cause the financial statements to be materially misstated. The auditor might determine the likely sources of potential misstatements by asking himself or herself "what could go wrong?" within a given significant account or disclosure.
.62 The risk factors that the auditor should evaluate in the identification of significant accounts and disclosures and their relevant assertions are the same in the audit of internal control over financial reporting as in the audit of the financial statements; accordingly, significant accounts and disclosures and their relevant assertions are the same for both audits.
Note: In the financial statement audit, the auditor might perform substantive auditing procedures on financial statement accounts, disclosures, and assertions that are not determined to be significant accounts and disclosures and relevant assertions.
.63 The components of a potential significant account or disclosure might be subject to significantly differing risks.
.64 When a company has multiple locations or business units, the auditor should identify significant accounts and disclosures and their relevant assertions based on the consolidated financial statements.
Factors Relevant to Identifying Fraud Risks
.65 The auditor should evaluate whether the information gathered from the risk assessment procedures indicates that one or more fraud risk factors are present and should be taken into account in identifying and assessing fraud risks. Fraud risk factors are events or conditions that indicate (1) an incentive or pressure to perpetrate fraud, (2) an opportunity to carry out the fraud, or (3) an attitude or rationalization that justifies the fraudulent action. Fraud risk factors do not necessarily indicate the existence of fraud; however, they often are present in circumstances in which fraud exists. Examples of fraud risk factors related to fraudulent financial reporting and misappropriation of assets are listed in AS 2401.85. These illustrative risk factors are classified based on the three conditions discussed in this paragraph, which generally are present when fraud exists.
Note: The factors listed in AS 2401.85 cover a broad range of situations and are only examples. Accordingly, the auditor might identify additional or different fraud risk factors.
.66 All three conditions discussed in the preceding paragraph are not required to be observed or evident to conclude that a fraud risk exists. The auditor might conclude that a fraud risk exists even when only one of these three conditions is present.
.67 Consideration of the Risk of Omitted, Incomplete, or Inaccurate Disclosures. The auditor's evaluation of fraud risk factors in accordance with paragraph .65 should include evaluation of how fraud could be perpetrated or concealed by presenting incomplete or inaccurate disclosures or by omitting disclosures that are necessary for the financial statements to be presented fairly in conformity with the applicable financial reporting framework.
.68 Presumption of Fraud Risk Involving Improper Revenue Recognition. The auditor should presume that there is a fraud risk involving improper revenue recognition and evaluate which types of revenue, revenue transactions, or assertions may give rise to such risks.
.69 Consideration of the Risk of Management Override of Controls. The auditor's identification of fraud risks should include the risk of management override of controls.
Note: Controls over management override are important to effective internal control over financial reporting for all companies, and may be particularly important at smaller companies because of the increased involvement of senior management in performing controls and in the period-end financial reporting process. For smaller companies, the controls that address the risk of management override might be different from those at a larger company. For example, a smaller company might rely on more detailed oversight by the audit committee that focuses on the risk of management override.
Factors Relevant to Identifying Significant Risks
.70 To determine whether an identified and assessed risk is a significant risk, the auditor should evaluate whether the risk requires special audit consideration because of the nature of the risk or the likelihood and potential magnitude of misstatement related to the risk.
Note: The determination of whether a risk of material misstatement is a significant risk is based on inherent risk, without regard to the effect of controls.
.71 Factors that should be evaluated in determining which risks are significant risks include:
Whether the risk is a fraud risk;
Note: A fraud risk is a significant risk.
Managing the risk of material misstatement in the purchasing process is critical. Identify two (2) different...
Managing the risk of material misstatement in the purchasing process is critical. Identify two (2) different industries and analyze how these risks differ from one industry to the other. Also, identify internal controls that could help to keep these misstatements to a minimum
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