Clarified Auditing Standards—Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement (AU-C 315)—Part 1

The Objective of AU-C 315

“The objective of the auditor is to identify and assess the risks of material misstatement, whether due to fraud or error, at the financial statement and relevant assertion levels through understanding the entity and its environment, including the entity's internal control, thereby providing a basis for designing and implementing responses to the assessed risks of material misstatement.”

Risk Assessment Procedures Identified in the Standard

Basic risk assessment procedures include:

• Inquiries of management, employees and others.
• Analytical procedures.
• Observation and inspection.

Information obtained from client acceptance and continuance decision-making, from previous engagements performed for a client and from fraud inquiries also provide sources for identifying and considering risks of material misstatement due to error or fraud.

The Practical Nature of Risk Assessment Procedures

Risk assessment procedures include all engagement activities from the planning phase up to the development of the audit plan or detailed audit program. Below is an outline and brief discussion of common risk assessment procedures and related documentation.

1. Creating and documenting client acceptance or continuance decisions.
2. Reviewing prior year audit documentation; considering findings and conclusions; adjusting journal entries and uncorrected audit differences; and assessing their impact on the current year’s risk assessment.
3. Reading the current year’s general ledger activity and preparing a memo documenting parameters and findings.
4. Performing and documenting other preliminary analytical procedures such as comparing the current year’s unadjusted account balances with prior year adjusted balances.
5. Preparing flowcharts or memos documenting the client’s accounting and internal control systems and the performance of systems walk-through procedures for major transactions cycles.
6. Calculating tolerable misstatement (performance materiality) by financial statement classification based on risk.
7. Completing applicable practice aids and other documentation from the firm’s accounting and auditing manuals.
8. Preparing a linking working paper combining risk of misstatements due to error and fraud to determine the level of risk of material misstatement for relevant assertions in material financial statement classifications.
9. Designing a detailed audit plan/program that links significant risks with appropriate procedures, i.e., tests of control, analytical procedures and/or detailed tests of balances.

 The risk assessment standards make clear that all risk assessment procedures produce substantive evidence that contributes toward accomplishing audit objectives. When considering the evidence necessary to decrease detection risk to an acceptably low level, obtaining evidence from the performance of risk assessment procedures will reduce the evidence required from other auditing procedures.

The Power to Audit Efficiently

Risk-driven approaches to engagements not only produce high quality, they can maximize audit efficiency. Understanding the opportunities the risk assessment standards provide to obtain substantive evidence in less costly ways, an auditor has the power to produce the most efficient audit in each engagement’s circumstances. Designing cost-beneficial audit strategies is decision-making of the highest order, the heart of an auditor’s professional judgment and result from the auditor’s effective application of risk assessment procedures. The next article will discuss the entity, its environment and its internal control.

More Information

My exclusive presentations of webcasts on CPE Credit.com and self-study courses covering various applications of auditing standards can be accessed by clicking the appropriate box on the left side of my home page, www.cpafirmsupport.com. Registered users accessing CPE webcasts and self-study courses on my website presented by myself and numerous other authors on a variety of professional topics receive a 20% discount on all registrations.

My assistance in CPA firm quality control consulting, audit planning and peer review preparation can be obtained by sending an email using the “Contact Us” tab on my home page.