Magazine article The CPA Journal

Understanding the Changes in Risk Assessment Standards

Magazine article The CPA Journal

Understanding the Changes in Risk Assessment Standards

Article excerpt

As a discussion leader for continu- ing professional education (CPE) courses for 25 years, the author has witnessed many CPAs struggle to adjust their audit approach to comply with new standards. For the past 18 months, tins has been vividly evident as auditors of small, nonpublic companies ponder how to effectively comply with the "Risk Assessment Suite" of Statements on Auditing Standards (SAS) 104-111.

Comparing Standards

The basic requirements under the new risk assessment standards can be traced to previously issued standards. What has changed is how diese standards are applied and the level of documentation needed to support an audit opinion. As shown in Exhibit 1, a comparison of prior and current standards reveals three key differences:

* The depth and documentation required to support an auditor's understanding of the client;

* A requirement to apply specific risk assessment procedures; and

* A more rigorous application of the "audit risk model."

Understanding Your Client

The need for auditors to understand their clients has long been recognized. SAS 22, Planning and Supervision, issued in 1978, states, "The auditor should obtain a knowledge of matters that relate to the nature of the entity's business, its organization, and its operating characteristics." The standard, however, provided little guidance on how to obtain this understanding, stating it is "obtained through experience with the entity or its industry and inquiry of personnel of the entity."

SAS 109, Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatements, not only reiterates the requirement of gaining an understanding of the client but also provides specific procedures to accomplish this task. Exhibit 2, based on the risk assessment standards, relates specific inputs and procedures to develop the auditor's understanding of the entity. SAS 109 states that although the auditor is not required to perform all risk assessment procedures for each input all risk assessment procedures should be performed with the objective of obtaining an overall understanding of the client.

The new standards also expect the auditor to bring knowledge gained from prior engagements forward to the current year. An underlying theme of the risk assessment standards is "What has changed?" An auditor's prior knowledge of a client should be updated for each engagement, based on the current business environment.

SAS 55, Consideration of Internal Control in a Financial Audit, required documenting an understanding of internal controls. That requirement has not changed. An important part of understanding the client is identification of controls and assessment of thei r design and implementation, regardless of whether the auditor intends to test the effectiveness of those controls. For immaterial accounts, this documentation might be limited to the identification of existing controls. Accounts reflecting a higher potential for material misstatement should have an increased level of documentation of relevant controls to support any audit procedures selected.

The auditor's documentation of understanding the client should, therefore, demonstrate that the auditor has considered each of the inputs and applied each risk assessment procedure. As Exhibit 2 shows, the documentation of an auditor's understanding, including internal controls, becomes a critical input into the application of the audit risk model and the assessment of the risk of material misstatements.

The Audit Risk Model

Consistent with prior standards, SAS 107, Audit Risk and Materiality in Conducting an Audit, also describes the audit risk model and defines the risk of material misstatement (RMM) as the combined assessments of inherent risk and control risk. Although they are presented in mathematical form, there is no requirement to measure the elements of the model in such terms. The standard's focus is on the relationships contained within the model:

Audit Risk = Inherent Risk × Control Risk × Detection Risk

Audit risk is the danger that the auditor will fail to detect material misstatements in the financial statements, if such misstatements exist. …

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