Response to Risk
Judgments about the risk of material misstatements due to fraud may affect the audit in the following ways:
1. Assignment of personnel and supervision.The personnel assigned to the engagement should have the knowledge, skill, and experience necessary to address the auditor's assessment of the level of risk of the engagement. The extent of supervision should also reflect the level of risk.
2. Accounting principles.The auditor should evaluate management's selection and application of significant accounting principles, particularly those relating to subjective measurements and complex transactions. The auditor should also consider whether the collective application of the principles indicates a bias that may create a material misstatement.
3. Predictability of audit procedures.The auditor should vary procedures from year to year to create an element of unpredictability. For example, the auditor may perform unannounced procedures or use a different sampling method.
(AU-C 240.29)
Adjusting the Nature, Timing, and Extent of Audit Procedures to Address Risk
The auditor may respond to identified risks by adjusting the nature, timing, and extent of audit procedures performed. Specifically:
● The nature of procedures may need to be modified to provide more reliable and persuasive evidence, or to corroborate management's representations. For example, the auditor may need to rely more on independent sources, physical observation of assets, or computer-assisted audit techniques (CAATs).
● The timing of procedures may need to be changed. For example, the auditor may decide to perform more procedures at year-end, rather than relying on tests from an interim date.
● The extent of procedures applied should reflect the assessment of fraud risk and may need to be adjusted. For example, the auditor may increase sample sizes, perform more detailed analytical procedures, or perform more computer-assisted audit techniques.
Appendix B of AU-C 240 contains the following examples of ways to modify the nature, timing, and extent of tests in response to identified risks of material misstatement due to fraud:
● Perform unannounced or surprise procedures at locations.
● Ask that inventories be counted as closely as possible to the end of the reporting period.
● Orally confirm with major customers and suppliers in addition to sending written confirmations.
● Send confirm requests to a specific party in an organization.
● Perform substantive analytical procedures using disaggregated data, such as comparing gross profit or operating margins by location, line of business, or month to auditor-developed expectations.
● Interview personnel involved in areas where a fraud risk has been identified to get their views about the risk and how controls address the risk.
● Discuss with other independent auditors auditing other subsidiaries, divisions, or branches the extent of work that should be performed to address the risk of fraud resulting from transactions and activities among those components.
● If the work of an expert becomes particularly significant with respect to a financial statement item for which the assessed risk of misstatement due to fraud is high, perform additional procedures relating to some or all of the expert's assumptions, methods, or findings to determine that the findings are not unreasonable, or engage another expert for that purpose.
● Perform audit procedures to analyze selected opening balance sheet accounts of previously audited financial statements to assess how certain issues involving accounting estimates and judgments (for example, an allowance for sales returns) were resolved with the benefit of hindsight.
Examples of Responses to Identified Risks of Misstatements from Fraudulent Financial Reporting
The following examples are from AU-C 240 Appendix B:
Revenue recognition. The auditor may consider:
● Performing substantive analytical procedures relating to revenue using disaggregated data, such as comparing revenue reported by month or by product line or business segment during the current reporting period with comparable prior periods.
● Confirming with customers certain relevant contract terms and the absence of side agreements, because the appropriate accounting often is influenced by such terms or agreements (for example, acceptance criteria, delivery and payment terms, the absence of future or continuing vendor obligations, the right to return the product, guaranteed resale amounts, and cancellation or refund provisions often are relevant in such circumstances).
● Inquiring of the entity's sales and marketing personnel or in-house legal counsel regarding sales or shipments near the end of the period and their knowledge of any unusual terms or conditions associated with these transactions.
● Being physically present at one or more locations at period-end to observe goods being shipped or being readied for shipment (or returns processing) and performing other appropriate cutoff procedures.
● For those situations for which revenue transactions are electronically initiated, processed, and recorded, testing controls to determine whether they provide assurance that recorded revenue transactions occurred and are properly recorded.
Inventory quantities. The auditor may consider:
● Examining the entity's inventory records to identify locations or items that require specific attention during or after the physical inventory count.
● Performing additional procedures during the count, such as rigorously examining the contents of boxes, checking for hollow squares in the manner in which goods are stacked, or examining the quality of liquid substances for purity, grade, or concentration.
● Performing additional testing of count sheets, tags, or other records to reduce the possibility of subsequent alteration or inappropriate compilation.
● Performing additional procedures to test the reasonableness of quantities counted, such as comparing quantities for the current period with prior periods by class or category of inventory or location.
● Using CAATs.
Management estimates. The auditor may want to supplement the audit evidence obtained. The auditor may:
● Engage a specialist to develop an independent estimate for comparison.
● Extend inquiries to individuals outside of management and the accounting department to corroborate management's ability and intent to carry out plans that are relevant to developing the estimate.
Examples of Responses to Identified Risks of Misstatements Arising from Misappropriation of Assets
The auditor will usually direct a response to identified risks of misstatements arising from misappropriation of assets to certain account balances. The scope of the work should be linked to the specific information about the identified misappropriation risk. (AU-C 240 Appendix B) The auditor may consider some of the procedures listed in the preceding section, “Examples of Responses to Identified Risks of Misstatements Arising from Fraudulent Financial Reporting.” However, in some cases, the auditor may:
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