Question

Elaborate on the following Chapter 4 points:

1: Define engagement risk

2: Define the achieved level of audit risk

3: Understand the risk when the client is focused on its PE ratio

4: Define detection risk

5: Understand the risk of material misstatement as compared to detection risk

6: Identify inherent risk factors pervasive in the client’s financial statements

7: Understand the relationship between the risk of material misstatement and substantive tests

Answer 1

1 .Engagement risk

Risk is the defining concept of an audit. Auditors examine businesses primarily to identify operational and financial risks. Both of these risk categories factor into a broader risk category, engagement risk. The 1995 Audit Risk Alert introduced the term engagement risk. It consists of three interrelated components: entity business risk, auditor business risk and audit risk.

Entity business risk, auditor business risk and audit risk threaten the reputation and effectiveness of the audit firm and contribute to overall engagement risk, which is the risk that an audit faces from association with a particular client. This includes the risk of material misstatement, the risk to one's reputation from being associated with a particular client, the inability of the client to pay the firm, or potential financial losses.

2. Achieved audit risk is the actual level of risk, after the audit is completed and an unqualified opinion issued, that the statements are materially misstated. ... The auditor will have sufficient competent evidence when the achieved audit risk equals desired audit risk.

3.P/E Ratio Analysis. Generally, the pe ratio indicates how many times earnings, the investors are willing to pay for the share. The P/E ratio analysis shows the direct relationship between the market price of the share of a company and its earnings. ... This ratio is useful only in comparing companies in the same industry.

The price-to-earnings (P/E) ratio is a fairly simple tool for assessing company value. Judging by how often the P/E ratio gets touted—by Wall Street analysts, the financial media and colleagues at the office water cooler—it's tempting to think it's a foolproof tool for making wise stock investment choices. Think again—the P/E ratio is not always reliable. There are plenty of reasons to be wary of P/E-based stock valuations

Auditor should concern about following risk :

Earnings can be affected by unusual gains or losses which sometimes obscure the true nature of the earnings metric. What's more, reported earnings can be manipulated by company management to meet earnings expectations, while creative accounting choices—shifting depreciation policies or adding or subtracting non-recurring gains and expenses—can make bottom line earnings numbers less and, in turn, P/E ratios, higher and the stock appear expensive. Investors need to be wary of how companies arrive at their reported EPS numbers. Appropriate adjustments often have to be done in order to obtain a more accurate measure of earnings than what is reported on the balance sheet.

Auditor should more concern about accuracy of EPS and MPS.

4.Detection Risk:

Detection risk is the possibility that an auditor will not locate a material misstatement in a client's financial statements via audit procedures. This is particularly likely when there are several misstatements that are individually immaterial, but which are material when aggregated. The outcome is that an auditor would conclude that there is no material misstatement of the financial statements when such an error actually exists, which would then lead to the issuance of an erroneously favorable audit opinion.

The auditor is responsible for managing detection risk. The level of detection risk can be reduced by conducting additional substantive tests, as well as by assigning the most experienced staff to an audit. There will always be some amount of detection risk in an audit, since audit procedures do not comprehensively examine every business transaction - instead, they only review a sampling of these transactions.

Detection is one of the three risk elements that comprise audit risk - which is the risk that an inappropriate audit opinion will be issued. The other two elements are inherent risk and control risk.

5.

The risk of material misstatement is the risk that the financial statements of an organization have been misstated to a material degree. This risk is assessed by auditors at the following two levels:

• At the assertion level. This is further subdivided into inherent risk and control risk. Inherent risk is the susceptibility of an assertion to misstatement because of error or fraud, before considering controls. Control risk is the risk of misstatement that will not be prevented or detected by a reporting entity's internal controls.

• At the financial statement level. Relates to the financial statements as a whole. This risk is more likely when there is a possibility of fraud.

When the risk of material misstatement is high, the level of detection risk is lowered (increases the amount of evidence obtained from substantive procedures). Doing so reduces the overall audit risk.

6.

Factors affecting account inherent risk include:

• Dollar size of the account.
• Liquidity.
• Volume of transactions.
• Complexity of the transactions.
• New accounting pronouncements.
• Subjective estimates.

7  performing substantive procedures at an interim date without performing procedures at a later date increases the risk that a material misstatement could exist in the year-end financial statements that would not be detected by the auditor.