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Preliminary analytical procedures
Mar 11

Preliminary Analytical Procedures

By Charles Hall | Auditing

Preliminary analytical procedures are used to identify material misstatements in financial statements. In this article, I explain how to create planning analytics and how to use them to identify potential misstatements. I also provide documentation tips. 

Preliminary analytical procedures

Preliminary Analytical Procedures

The auditing standards provide four risk assessment procedures: 

  1. Inquiry
  2. Observation
  3. Inspection
  4. Analytical procedures

I previously provided you with information about the first three risk assessment procedures. Today, I provide you with the fourth, analytical procedures.

While analytical procedures should occur at the beginning and the end of an audit, this post focuses on preliminary analytical procedures (sometimes called a preliminary analytical review).

Below I provide the quickest and best way to develop audit planning analytics

What are Analytics?

If you're not an auditor, you may be wondering, "what are analytics?" Think of analytics as the use of numbers to determine reasonableness. For example, if a company's cash balance at December 31, 2020, was $100 million, is it reasonable for the account to be $5 million at December 31, 2021? Comparisons such as this one assist auditors in their search for errors and fraud.

Preliminary Analytical Procedures Overview

We'll cover the following:

  • The purpose of preliminary analytical procedures 
  • When to create planning analytics (at what stage of the audit)
  • Developing expectations 
  • The best types of planning analytics
  • How to document preliminary analytical procedures
  • Developing conclusions 
  • Linkage to the audit plan

(The following video comes from my Audit Risk Assessment Made Easy YouTube playlist. These videos correspond to my book of the same name. See it on Amazon.)

Purpose of Preliminary Analytical Procedures

Analytical procedures used in planning an audit should focus on identifying risks of material misstatement. Your goal as an auditor is to render an opinion regarding the fairness of the financial statements. So, like a good sleuth, you are surveying the accounting landscape to see if material misstatements exist.

A detective investigates a crime scene using various tools: fingerprints, forensic tests, interviews, timelines. Auditors have their own tools: inquiry, observation, inspection, analytical procedures. Sherlock Holmes looks for the culprit. The auditor (and I know this isn't as sexy) looks for material misstatements. 

The detective and the auditor are both looking for the same thing: evidence. And the deft use of tools can lead to success. A key instrument (procedure) available to auditors is preliminary analytical procedures.

When to Create Planning Analytics

Create your preliminary analytics after gaining an understanding of the entity. Why? Context determines reasonableness of numbers. And without context (your understanding of the entity), changes in numbers from one year to the next may not look like a red flag--though maybe they should.

Therefore, learn about the entity first. Are there competitive pressures?  What are the company's objectives? Are there cash flow issues? What is the normal profit margin percentage? Does the organization have debt? Context creates meaning.

Additionally, create your comparisons of numbers prior to creating your risk assessments. After all, the purpose of the analytical comparisons is to identify risk.

But before creating your planning analytics, you first need to know what to expect.

Developing Expectations 

Knowing what to expect provides a basis for understanding the changes in numbers from year to year. 

Expectations can include:

  • Increases in numbers
  • Decrease in numbers
  • Stable numbers (no significant change)

In other words, you can have reasons to believe payroll (for example) will increase or decrease. Or you might anticipate that salaries will remain similar to last year.

Examples of Expectations Not Met

Do you expect sales to decrease 5% based on decreases in the last two years? If yes, then an increase of 15% is a flashing light.

Or maybe you expect sales to remain about the same as last year? Then a 19% increase might be an indication of financial statement fraud.

But where does an auditor obtain expectations?

Sources of Expectations

Expectations of changes can come from (for example):

  • Past changes in numbers 
  • Discussions with management about current year operations
  • Reading the company minutes
  • Staffing reductions
  • Non-financial statistics (e.g., decrease the number of widgets sold)
  • A major construction project

While you'll seldom know about all potential changes (and that's not the goal), information--such as that above--will help you intuit whether change (or a lack of change) in an account balance is a risk indicator.

Now, let's discuss the best types of planning analytics. 

The Best Types of Planning Analytics

Auditing standards don't specify what types of planning analytics to use. But some, in my opinion, are better than others. Here's my suggested approach (for most engagements). 

Audit Planning Analytics

Comparative Numbers

First, create your planning analytics at the financial statement reporting level. Why? Well, that's what the financial statement reader sees. So, why not use this level (if you can)? (There is one exception in regard to revenues. See Analytics for Fraudulent Revenue Recognition below.)

The purpose of planning analytics is to ferret out unexpected change. Using more granular information (e.g., trial balance) muddies the water. Why? There's too much information. You might have three hundred accounts in the trial balance and only fifty at the financial statement level. Chasing down trial-balance-level changes can be a waste of time. At least, that's the way I look at it.

Comparative Ratios

Second, add any key industry ratios tracked by management and those charged with governance. Often, you include these numbers in your exit conference with the board (maybe in a slide presentation). If those ratios are important at the end of an audit, then they're probably important in the beginning.

Examples of key industry ratios include:

  • Inventory turnover
  • Return on equity
  • Days cash on hand
  • Gross profit 
  • Debt/Equity 

Other Metrics

Other metrics such as earnings before interest, taxes, depreciation, and amortization (EBITDA) are consequential for some companies. If relevant, include those.

Hence, create planning analytics that align with the company’s focal points. And how do you know what those are? Read the company’s minutes before you create your preliminary analytics. Most of the time you’ll see the tracked numbers there. 

One last thought about analytical types. When relevant, use nonfinancial information, such as the number of products sold. If a company sells just three or four products and you have the sales statistics, why not compute the estimated revenue and compare it to the recorded revenue? It makes sense to do so. After all, the auditing standards say that preliminary analytics may include both financial and nonfinancial information. 

Okay, so we know what analytics to create, but how should we document them?

Analytics for Fraudulent Revenue Recognition

AU-C 240 says the auditor should include preliminary analytics relating to revenue accounts.

AU-C 240 suggests a more detailed form of analytics for revenues such as:

  • a comparison of sales volume with production capacity
  • a trend analysis of revenues by month and sales returns by month 
  • a trend analysis of sales by month compared with units shipped to customers

In light of these suggested procedures, it may be prudent to create revenue analytics at a more granular level than that shown in the financial statements.

How to Document Preliminary Planning Analytics

Here are my suggestions for documenting preliminary planning analytics.

  1. Document overall expectations.
  2. Include comparisons of prior-year/current-year numbers at the financial statement level. (You might also include multiple prior year comparisons if you have that information.)
  3. Document key industry ratio comparisons.
  4. Summarize your conclusions. Are there indicators of increased risks of material misstatement? Is yes, say so. If no, say so.

Once you create your conclusions, place any identified risks on your summary risk assessment work paper (where you assess risk at the transaction level--e.g., inventory).

Use Filtered Analytical Reports with Caution (if at all)

Some auditors use filtered trial balance reports for their analytics. For instance, all accounts with changes of greater than $30,000. There is a danger in using such thresholds. 

What if  you expect a change in sales of 20% (approximately $200,000) but your filters include:

  •  all accounts with changes greater than $50,000, and 
  • all accounts with changes of more than 15%

If sales remain constant, then this risk of material misstatement (you expected change of 20%, but it did not happen) fails to appear in the filtered report. The filters remove the sales account because the change was minimal. Now, the risk may go undetected.

Developing Conclusions

I am a believer in documenting conclusions on key work papers. So, how do I develop those conclusions? And what does a conclusion look like on a planning analytics work paper?

First, develop your conclusions. How? Scan the comparisons of prior year/current year numbers and ratios. We use our expectations to make judgments concerning the appropriateness of changes and of numbers that remain stable. Remember this is a judgment, so, there's no formula for this.

No Risk Identified

Now, you'll document your conclusions. But what if there are no unexpected changes? You expected the numbers to move in the manner they did. Then no identified risk is present. Your conclusion will read, (for example):

Conclusion: I reviewed the changes in the accounts and noted no unexpected changes. Based on the planning analytics, no risks of material misstatement were noted.

Risk Identified

Alternatively, you might see unexpected changes. You thought certain numbers would remain constant, but they moved significantly. Or you expected material changes to occur, but they did not. Again, document your conclusion. For example:

Conclusion: I expected payroll to remain constant since the company's workforce stayed at approximately 425 people. Payroll expenses increased, however, by 15% (almost $3.8 million). I am placing this risk of material misstatement on the summary risk assessment work paper at 0360 and will create audit steps to address the risk.

Now, it's time to place the identified risks (if there are any) on your summary risk assessment form.

Linkage to the Audit Plan

I summarize all risks of material misstatements on my summary risk assessment form. These risks might come from walkthroughs, planning analytics or other risk assessment procedures. Regardless, I want all of the identified risks--those discovered in the risk assessment process--in one place.

The final step in the audit risk assessment process is to link your identified risks to your audit program

Overview of Risk Assessment and Linkage

Now, I tailor my audit program to address the risks. Tailoring the audit program to respond to identified risks is known as linkage.

Audit standards call for the following risk assessment process:

  • Risk assessment procedures (e.g., planning analytics)
  • Identification of the risks of material misstatement
  • Creation of audit steps to respond to the identified risks (linkage)

Summary of Preliminary Analytical Procedure Considerations

So, now you know how to use planning analytics to search for risks of material misstatement--and how this powerful tool impacts your audit plan.

Let's summarize what we've covered:

  1. Planning analytics are created for the purpose of identifying risks of material misstatement
  2. Develop your expectations before creating your planning analytics (learn about the entity's operations and objectives; review past changes in numbers for context--assuming you've performed the audit in prior years)
  3. Create analytics at the financial statement level, if possible
  4. Use key industry ratios 
  5. Conclude about whether risks of material misstatement are present
  6. Link your identified risks of material misstatement to your audit program

So there you are. I hope you've found this article useful. For more information about risk assessment, check out my book Audit Risk Assessment Made Easy, available on Amazon. 

First-Year Businesses and Planning Analytics

You may be wondering, "but what if I my client is new?" New entities don't have prior numbers. So, how can you create planning analytics? 

First Option

One option is to compute expected numbers using non-financial information. Then compare the calculated numbers to the general ledger to search for unexpected variances.

Second Option

A second option is to calculate ratios common to the entity’s industry and compare the results to industry benchmarks.

While industry analytics can be computed, I’m not sure how useful they are for a new company. An infant company often does not generate numbers comparable to more mature entities. But we’ll keep this choice in our quiver--just in case.

Third Option

A more useful option is the third: comparing intraperiod numbers. 

Discuss the expected monthly or quarterly revenue trends with the client before you examine the accounting records. The warehouse foreman might say, “We shipped almost nothing the first six months. Then things caught fire. My head was spinning the last half of the year.” Does the general ledger reflect this story? Did revenues and costs of goods sold significantly increase in the latter half of the year?

Fourth Option

The last option we’ve listed is a review of the budgetary comparisons. Some entities, such as governments, lend themselves to this alternative. Others, not so–those that don’t adopt budgets.

Summary

So, yes, it is possible to create useful risk assessment analytics–even for a first-year company.

Risk assessment mistakes
Feb 11

15 Risk Assessment Mistakes CPAs Make

By Charles Hall | Accounting and Auditing

Here are 15 risk assessment mistakes. Have you seen these?

Risk assessment mistakes

  1. Assessing control risk at high with no understanding of internal controls and no walkthroughs (in other words, defaulting to high control risk)
  2. Seeing significant internal control problems, assessing control risk at high, then performing routine audit procedures (and no extended procedures)
  3. Assessing inherent risk too high (resulting in unnecessary responses–audit procedures)
  4. Assessing inherent risk too low (resulting in adequate responses–audit procedures)
  5. Not documenting why inherent risks are assessed as they are
  6. Seeing risks of material misstatement in the performance of risk assessment procedures (e.g., preliminary analytics), but not documenting those on the summary risk assessment form
  7. Adding audit procedures for assertions that are not relevant (wasted hours of work)
  8. Not documenting linkage between the risks of material misstatement by assertion to the planned audit procedures
  9. Failing to document an understanding of the entity and its industry
  10. Assessing control risk below high without the support of a test of controls
  11. Defaulting to a test of details rather than performing a test of controls for effectiveness when the test of details takes more time than the test of controls (not necessarily wrong, just takes more time)
  12. Not identifying significant risks (and not performing needed extended procedures)
  13. Not understanding how weak internal controls affect the risk of material misstatement
  14. Not giving sufficient attention to internal controls because “my controls risk will be assessed at high anyway”
  15. Doing the same-as-last-year without determining if last year’s approach was correct and without determining if new risks of material misstatement are present

Review one of your audit files and see if any of these risk assessment mistakes are present.

Want to understand risk assessment? Check out my risk assessment book on Amazon.

significant risk
Feb 08

Significant Risks in Audits of Financial Statements

By Charles Hall | Auditing

Peer reviews find that many CPA firms don't identify significant risks in audits, and that's a problem. Why? Because they are the seedbed of many material misstatements. And when material misstatements are not identified, audit failure often occurs.

Below, I will tell you how to identify, assess, and respond to significant risks.

I also explain the new requirement to communicate significant risks to those charged with governance.  

significant risk

Defining Significant Risk

The Auditing Standards Board previously defined significant risks as those deserving special audit consideration. They've amended this definition in SAS 145 to focus on the inherent risk characteristics rather than the response

For example, a highly complex receivable allowance is inherently risky because it's subjective and complicated. Yes, we will give it special audit consideration. But it's a significant risk because of its nature (subjective and complex), not because of our response (re-computing the estimate and comparing it with prior periods, for example). 

How Many Significant Risks?

At least one significant risk exists in most audits, and frequently there are more. The number depends on the entity, its environment, the types of services it provides or goods it sells, the complexity of its accounts, the subjectivity of determining balances, the susceptibility of accounts to bias or fraud, and the level of change.

Defined in SAS 145

SAS 145, Understanding the Entity and Its Environment and Assessing the Risk of Material Misstatement, defines significant risk in terms of likelihood and magnitude. The threat must be likely, and the result must be material. (See my SAS 145 article.)

The audit standard defines the risk as one close to the upper end of the spectrum of inherent risk without regard for controls. In other words, we consider the inherent risk factors, and we disregard internal controls as we identify these risks.

Align Inherent Risk with Significant Risk

Notice that significant risks are based solely upon inherent risk. So don’t make the mistake of identifying such a risk and then assessing inherent risk below high. After all, the definition says close to the upper end of the spectrum of inherent risk.

Suppose, for example, you identify a significant risk for the allowance for uncollectible receivables, an estimate, due the concerns about the valuation assertion (because it's complex and subjective; see inherent risk factors below). Then the inherent risk for the valuation assertion must be high (or max). 

It's useful to think of inherent risk on a scale of 1 to 10, with 10 being high risk. If you believe the inherent risk is a 9 or a 10 (close to the upper end of the spectrum of inherent risk), then a significant risk is present. Though auditors commonly use low, moderate, high to measure inherent risk, the audit standards don't specify how this is to be done. I'm not saying don't use low, moderate, high, only that thinking of inherent risks on scale of 1 to 10 helps me evaluate risk and to determine whether a significant risk is present.

Inherent Risk Factors

And what are the inherent risk factors? 

  • Complexity
  • Subjectivity
  • Change
  • Uncertainty
  • Susceptibility to misstatement due to management bias or other fraud risk factors (in terms of how they affect inherent risk)

Two Questions to Consider

So the auditor reviews an assertion and asks, "In light of these risk factors, what is the probability of misstatement without regard for controls?" The auditor also asks, "Would a material misstatement occur?" So we consider two things:

  • Is it highly likely that a misstatement will occur for the assertion (without regard for controls)?
  • Will the misstatement be material?

If both answers are yes, it's a significant risk.

Responses to Significant Risks

Peer reviews find that auditors sometimes identify these risks but plan inadequate responses. If the risk is significant, then a strong response is necessary. 

For example, if inventory obsolescence is an issue, the auditor should plan procedures to identify the impaired items and test for appropriate valuation. You may need a specialist in such a situation. So, what would be an inadequate response?  Performing basic inventory procedures. Additional procedures, sometimes referred to as extended steps, are necessary to address the inventory valuation assertion.

As you plan the additional audit procedures, link them from the identified risk (usually on your summary risk assessment form) to your responses (usually on your audit program). In the inventory example, you would link the risk for the valuation assertion to the inventory audit steps (the extended steps to identify and value the impaired items).


You must also communicate these risks to those charged with governance. 

Communicating Significant Risks

Communicate the significant risks to those charged with governance as you implement SAS 134, Auditor Reporting and Amendments, Including Amendments Addressing Disclosures in the Audit of Financial Statements (required for December 31, 2021 year-end engagements and after).

(See my SAS 134 article to understand the types of audit opinions.)  

Present guidance states that significant risks are those that deserve special audit consideration, so you'll use that definition until SAS 145 is implemented. (Even so SAS 145 will help you understand these risks now.)

significant risk

How to Communicate 

You can communicate significant risks in one of three ways:

  1. Engagement letter
  2. Planning letter to those charged with governance
  3. Verbally to the board with documentation of that communication in the audit file--this could be a separate Word document that says who you talked with, when, and the significant risk areas communicated. 

The Communication Change

SAS 134 amended AU-C 260.11 (AU-C 260 The Auditor's Communication with Those Charged with Governance) as follows (amended language is underlined):

The auditor should communicate with those charged with governance an overview of the planned scope and timing of the audit, which includes communicating about the significant risks identified by the auditor.

Sample Significant Risk Language 

Here's an example of the language to be used in any of the three options above:

The anticipated significant risk areas in the audit are:

  1. receivables/revenues,
  2. the allowance for uncollectibles 
  3. the pension liability and disclosure. 

Aligning the Communication with Workpapers

The significant risk areas communicated to the board during planning should align with those identified in your workpapers. You could, however, not know all of the risk areas when you create your initial communication. It's even possible you might not identify a these risks until you are well into the engagement. So the initial significant risk communication and the identified risks in the audit file could be different. You can communicate any additional risks in your final communication to those charged with governance. 

Why are we making this communication the board? Well the board governs the entity, so they need to be aware of areas with a higher risk of potential misstatements. 

Optional Communication 

The explanatory information that accompanies AU-C 260 (specifically .A21) states you may include in the governance communication how you (as the auditor) are going to address the significant risks, but this is optional.  

Audit Risk Assessment Book on Amazon

See my book on Amazon: Audit Risk Assessment Made Easy, Seeing What Others Miss.

 

control risk
Jan 14

Control Risk: Financial Statement Audits

By Charles Hall | Auditing , Risk Assessment

Control risk continues to create confusion in audits. Some auditors assess control risk at less than high when they shouldn't. Others assess control risk at high when it would be better if they did not. The misunderstandings about this risk can result in faulty audits and problems in peer review. In this article, I explain what control risk is and how you can best leverage it to perform quality audits in less time. 

control risk

Control Risk Defined

What is control risk? It’s the chance that an entity’s internal controls will not prevent or detect material misstatements in a timely manner. 

Companies develop internal controls to manage inherent risk. The greater the inherent risk, the greater the need for controls.

Audit Risk Model

As we begin this article, think about control risk in the context of the audit risk model:

Audit risk = Inherent risk X Control risk X Detection risk

Recall the client’s risk is made up of inherent risk and control risk. And the remainder, detection risk, is what the auditor controls. Auditors gain an understanding of inherent risk and control risk. Why? To develop their audit plan and lower their detection risk (the risk that the audit will not detect material misstatements). Put more simply, the auditor understands the client’s risk in order to lower her own.

Further Audit Procedures

And how does the auditor reduce detection risk? With further audit procedures. Those include test of controls and substantive procedures (test of details or substantive analytics). 

After the auditor gains an understanding of the entity and its environment, including internal controls, control risk is often assessed at high. Why? Two reasons: one has to do with efficiency and the other with weak internal controls.

 

Assessing Control Risk at High

Consider the first reason for high control risk assessments: efficiency

Control risk can be assessed at high, even if—during your walkthroughs— you see that controls are properly designed and in use. But why would you assess this risk at high when controls are okay? 

Let me answer that question with a billing and collection example. 

Risk At High: Efficiency Decision

You can test billing and collection internal controls for effectiveness (assuming your walkthrough reveals appropriate controls). But if this test takes eight hours and a substantive approach takes five hours, which is more efficient? Obviously, the substantive approach. And if you use a fully substantive approach, you must assess control risk at high for all relevant assertions. 

At this point, you may still be thinking, But, Charles, if controls are appropriately designed and implemented, why is control risk high? Because a test of controls is required for control risk assessments below high: the auditor needs a basis (evidence) for the lower assessment. And a walkthrough is not (in most cases) considered a test of controls for effectiveness: it does not provide a sufficient basis for the lower risk assessment. A walkthrough provides an initial impression about controls, but that impression can be wrong. That’s why a test of controls is necessary when control risk is below high, to prove the effectiveness of the control.

In our example above, a substantive approach is more efficient than testing controls. So we plan a substantive approach and assess control risk at high for all relevant assertions. 

Risk at High: Weak Controls

Now, let’s look at the second reason for high control risk assessments: weak internal controls. Here again, allow me to explain by way of example. 

If the billing and collection cycle walkthrough reveals weak internal controls, then control risk is high. Why? Because the controls are not designed appropriately or they are not in use. In other words, they would not prevent or detect a material misstatement. You could test those controls for effectiveness. But why would you? They are ineffective. Consequently, risk has to be high. Why? Again, because there is no basis for the lower risk assessment. (Even if you tested controls, the result would not support a lower risk assessment: the controls are not working.)

If, on the other hand, controls are appropriate, then you might test them (though you are not required to). 

Assessing Control Risk at Less than High

What if, based on your walkthrough, controls are okay. And you believe the test of controls will take four hours while a substantive approach will take eight hours? Then you can test controls for effectiveness. And if the controls are effective, you can assess the risk at less than high. Now you have support for the lower risk assessment. 

But what if you test controls for effectiveness and the controls are not working? Then a substantive approach is your only choice. 

Many auditors don’t test controls for this reason: they are afraid the test of controls will prove the controls are ineffective. For example, if you test sixty transactions for the issuance of a purchase order, and seven transactions are without purchase orders, the sample does not support effectiveness. The result: the test of controls is a waste of time. 

Some auditors mistakenly believe they don’t need an understanding of controls because they plan to use a fully substantive audit approach. But is this true?

Fully Substantive Audit Approach

Weak internal controls can result in more substantive procedures, even if you normally use a substantive approach

Suppose you assess control risk at high for all billing and collection cycle assertions and plan to use a fully substantive approach. Now, consider two scenarios, one where the entity has weak controls, and another where controls are strong.

Billing and Collection Cycle - Weak Controls

Think about a business that has a cash receipt process with few internal controls. Suppose the following is true:

  • Two employees receipt cash  
  • They both work from one cash drawer 
  • The two employees provide receipts to customers, but only if requested
  • They apply the payments to the customer’s accounts, but they also have the ability to adjust (reduce or write off) customer balances 
  • At the end of the day, one of the two employees creates a deposit slip and deposits the money at a local bank (though this is not always done in a timely manner)
  • These same employees also create and send bills to customers 
  • Additionally, they reconcile the related bank account 

Obviously, a segregation of duties problem exists and theft could occur. For example, the clerks could steal money and write off the related receivables. Child’s play. 

Billing and Collection Cycle - Strong Controls

But suppose the owner detects theft and fires the two employees. He does background checks on the replacements. Now the following is true:

  • A separate cash drawer is assigned to each clerk
  • The controller is required to review customer account adjustments on a daily basis (the controller can’t adjust receivable accounts)
  • The cash receipt clerks reconcile their daily activity to a customer receipts report, and the money along with the report is provided to the controller 
  • The controller counts the daily funds received and reconciles the money to the cash receipts report
  • Then the controller creates a deposit slip and provides the funds and deposit slip to a courier
  • Once the deposit is made, the courier gives the bank deposit receipt to the controller
  • A fourth person (that does not handle cash) reconciles the bank statement in a timely manner
  • The monthly customer bills are created and mailed by someone not involved in the receipting process
  • Moreover, the owner reviews a monthly cash receipts report 

Now, let me ask you: would you use the same substantive audit procedures for each of the above scenarios? Hopefully not. The first situation begs for a fraud test. For example, we might test the adjustments to receivables on a sample basis. Why? To ensure the clerks are not writing off customer balances and stealing cash. 

Audit Procedures: Basic and Extended

Basic audit procedures for the billing and collection cycle might include:

  • Test the period-end bank reconciliation
  • Create substantive analytics for receivable balances and revenues
  • Confirm receivable accounts and examine subsequent receipts

We perform these basic procedures whether controls are good or weak. But we would add—when controls are weak and might allow theft—extended substantive procedures such as testing accounts receivable adjustments. 

Do you see how the understanding of controls impacts planning (even when control risk is assessed at high)? If we were unaware of the control weaknesses, we would not plan the needed fraud detection procedures. 

In summary, we need to understand controls even if we plan to use a fully substantive approach, and even if risks are assessed at high for all assertions. More risk means more audit work. 

A Simple Summary

  • Control risk is the probability that an entity’s internal controls will not prevent or detect material misstatements in a timely manner
  • Internal control weaknesses may require a control risk assessment of high
  • Control risk can only be assessed below high when a test of control proves the control to be effective (the test of control provides the basis for the lower risk assessment)
  • If walkthroughs show controls to be appropriately designed and implemented, the auditor can (1) assess control risk at high and use a fully substantive approach, or (2) assess control risk below high and test controls for effectiveness, whichever is most efficient
  • Even if an auditor intends to use a fully substantive approach, walkthroughs are necessary to determine if additional substantive tests are needed; additional substantive procedures may be necessary when material fraud is possible due to internal control weaknesses

See my inherent risk article here

For additional information about risk assessment, see the AICPA's SAS 145, Understanding the Entity and Its Environment and Assessing the Risk of Material Misstatement The guidance was issued in October 2021. 

SAS 145
Jan 10

SAS 145: New Risk Assessment Standard

By Charles Hall | Auditing

Statement on Auditing Standards No. 145 (SAS 145), Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement, updates the risk assessment standards. Auditors need to be aware of these upcoming changes. 

Conceptually, risk assessment remains the same, but some particulars are different and significantly affect how you audit. SAS 145 is voluminous, but below I summarize the salient points to make it easy for you to digest--or, at least, as easy as I could. 

SAS 145

SAS 143, Auditing Accounting Estimates and Related Disclosures, introduced some concepts used in SAS 145. Those concepts include:

  • Inherent risk factors
  • Spectrum of inherent risk
  • Separate assessments of inherent risk and control risk

You’ll see several new definitions below. Understanding those is critical to understanding SAS 145. 

SAS 145 Topics

This article addresses the following SAS 145 topics:

  • Separate inherent and control risk assessments
  • Assessing control risk at the maximum level
  • Significant risks
  • Inherent risk factors and spectrum of risk
  • Relevant assertions
  • Significant classes of transactions, account accounts, and disclosures
  • Stand-back requirement
  • Scalability
  • Professional skepticism
  • Information technology (IT) controls
  • System of internal control
  • Increasing complexity of entities and auditing
  • Documentation requirements
  • Effective date of SAS 145

Separate Inherent and Control Risk Assessments

Most auditors have assessed inherent and control risk separately for some time, but those separate assessments were previously not required. SAS 145, however, requires that auditors individually assess these two risks at the assertion level. Interestingly, documenting a combined inherent and control risk assessment is not required. 

You can assess inherent risk and control risk in various ways; the standard does not specify a particular means of doing so. For instance, you might use high, moderate, or low; or use a scale of one to ten (more about this in a moment). 

Assessing Control Risk at the Maximum Level

Many auditors assess control risk at high or maximum, regardless of the internal control structure--whether the controls are designed appropriately and implemented or not. You might plan to use a fully substantive approach; for example, when substantive procedures take less time than testing controls for effectiveness.

If you decide not to test controls for effectiveness, SAS 145 requires that you assess control risk at the maximum (or high) so that the risk of material misstatement is the same as the inherent risk assessment.

So, if control risk is assessed at maximum, can the evaluation of the design and implementation of controls (i.e., walkthroughs) still impact the planned audit procedures? Yes. Increased risk leads to a change in nature, timing, and extent of planned audit procedures. For example, if your walkthrough reveals a lack of segregation of duties, you may need to add more substantive procedures to address fraud risk.   

On the other hand, if a test of controls for effectiveness supports a lower control risk, you can bring the assessment below maximum. But you cannot lower control risk without the support of a test of controls for effectiveness. 

Your inherent risk assessment is crucial if you use a fully substantive approach. Why? Because SAS 145 requires that inherent risk be the same as the risk of material misstatement. If your inherent risk is assessed higher than it should be, you’ll perform unnecessary work to address the risk and waste time. 

Significant Risks

The Auditing Standards Board provides a new definition for significant risks. The first part of the definition (see paragraph 12 of SAS 145 for the full definition) is as follows:

A significant risk is an identified risk of material misstatement for which the assessment of inherent risk is close to the upper end of the spectrum of inherent risk due to the degree to which inherent risk factors affect the combination of the likelihood of a misstatement occurring and the magnitude of the potential misstatement should that misstatement occur. 

(Note - the blog author bolded some words in the definition above for emphasis.)

significant risks

The prior significant risk definition focused on the response to the risk, not the risk itself. That guidance said it was a risk that needed special audit consideration

The new definition focuses on the risk itself. To be clear, the risk of material misstatement. Notice the new definition requires consideration of likelihood and magnitude. In other words, probability and dollar impact. Also, notice the description is based solely on inherent risk, with no consideration of control risk. (See my article about significant risks.)

Inherent Risk Factors and Spectrum of Risk

SAS 145 defines inherent risk factors as:

Characteristics of events or conditions that affect the susceptibility to misstatement, whether due to fraud or error, of an assertion about a class of transactions, account balance, or disclosure, before consideration of controls. Such factors may be qualitative or quantitative and include complexity, subjectivity, change, uncertainty, or susceptibility to misstatement due to management bias or other fraud risk factors insofar as they affect inherent risk. 

Depending on the degree to which the inherent risk factors affect the susceptibility of an assertion to misstatement, the level of inherent risk varies on a scale that is referred to as the spectrum of inherent risk.

(Note - the blog author bolded some words in the definition above for emphasis.)

Inherent Risk Factors

Consider the likelihood of misstatement in light of the inherent risk factors, including:

  • Complexity
  • Subjectivity
  • Change
  • Uncertainty
  • Susceptibility to misstatement due to management bias or other fraud risk factors (in terms of how they affect inherent risk)

So as you consider the inherent risk of an assertion, use these factors to determine the likelihood of misstatement. Then consider the magnitude of the potential misstatement. If the risk is close to the upper end of the spectrum of risk (for inherent risk) and the potential misstatement is material, then the entity has a significant risk. 

Ten-Point Scale, An Example

I like to evaluate significant risks on a ten-point scale, with ten being the highest risk. While SAS 145 does not use such an illustration, a nine or a ten is a significant risk, provided it can lead to a material misstatement. For example, a bank’s allowance for loan losses is usually a significant risk because it is a complex estimate in a material account balance. In making this assessment, we disregard internal controls. 

One additional change is SAS 145 removes the requirement to determine whether there are significant risks at the financial statement level. 

The term relevant assertion has also changed. 

Relevant Assertions

Using SAS 145, relevant assertions are based on classes of transactions, account balances, and disclosures with an identified risk of material misstatement.

Before SAS 145, we looked at relevant assertions as they related to material classes of transactions, account balances, and disclosures. And relevant assertions were those that had a meaningful bearing on whether an account was fairly stated. (I never knew what meaningful bearing meant.)

The new relevant assertion definition is clearer. Assertions are considered in light of:

  • Likelihood of misstatement
  • Magnitude of misstatement

Relevant Assertion Definition

In SAS 145, a relevant assertion is defined as:

An assertion about a class of transactions, account balance, or disclosure is relevant when it has an identified risk of material misstatement. A risk of material misstatement exists when (a) there is a reasonable possibility of a misstatement occurring (that is, its likelihood), and (b) if it were to occur, there is a reasonable possibility of the misstatement being material (that is, its magnitude). The determination of whether an assertion is a relevant assertion is made before consideration of any related controls (that is, the determination is based on inherent risk).

(Note - the blog author bolded some words in the definition above for emphasis.)

Probability and Dollar Impact

A relevant assertion is an identified risk of material misstatement when a reasonable possibility of its occurrence is present. Reasonable possibility means a more than a remote chance of happening. And if it happens, a material misstatement must be possible. Again we see an emphasis upon probability and dollar impact. And again, internal controls are ignored in making this determination. That is, inherent risk is the basis for determining which assertions are relevant.

Inventory Example

As an example, suppose high-technology components comprise inventory that becomes obsolete quickly. Your valuation assertion is inherently risky, and if inventory is a significant account balance, then valuation is a relevant assertion. Notice we made this determination without regard for the related controls. Moreover, we believe there is a reasonable possibility of obsolescence. 

Once again, we see that inherent risk is vital in SAS 145.

We said that relevant assertions relate to significant classes of transactions, account balances, and disclosures. But what are significant classes?

Significant Classes of Transactions, Account Balances, and Disclosures

In SAS 145, significant classes of transactions, account balances, or disclosures are defined in the following manner:

Significant class of transactions, account balance, or disclosure. A class of transactions, account balance, or disclosure for which there is one or more relevant assertions.

So a significant class is one with a relevant assertion--one where the likelihood of material misstatement is more than remote. 

So, if an account balance like receivables, for example, has a relevant assertion, it’s a significant class.

Purpose of the Definition

The purpose of this definition is to provide clarification concerning the scope of the auditor’s work. In other words, this definition tells us where to focus. We’ll perform risk assessment procedures and assess risk in the significant classes of transactions, account balances, and disclosures. It is in these areas where we will plan responses to the identified risks therein. SAS 145 requires substantive procedures for each significant class of transactions, account balances, and disclosures with relevant assertions. 

Consider this: if plant, property, and equipment (PP&E) is material, but there is no relevant assertion for the account balance, it is not a significant area. Suppose a company has $10 million in PP&E (a material balance) and it purchases no new capital assets during the year. There is only one PP&E asset, a building, which has appreciated. Is there a relevant assertion? Probably not. Why? There is little likelihood of material misstatement. 

Now change the scenario and suppose the building suffers an earthquake. Is PP&E a significant class? Yes, if substantial damage occurred. Why? Because you now have a relevant assertion: valuation.  

Stand-Back Requirement

Once you have designated all significant classes of transactions, account balances, and disclosures, evaluate all remaining material areas to see if the initial scope determination is appropriate. Is there a remaining account balance, transaction class, or disclosure that needs our attention, even though it did not qualify as a significant area? If yes, then plan audit procedures accordingly. 

SAS 145

The main point here is that the auditor focuses upon significant classes of transactions, account balances, and disclosures first (those with relevant assertions) and then remaining material amounts (which don’t have relevant assertions). For instance, say you choose cash, receivables/revenues, payables/expenses, and payroll as your significant areas, but not plant, property, and equipment (PP&E) because it has no relevant assertion. In the stand-back phase, ask yourself if PP&E deserves audit scrutiny. If it does, plan PP&E audit procedures. 

A company might have disclosures that are not significant (e.g., executive compensation), but you decide to audit it anyway. Why? You believe the scope of your planned audit is incomplete without it. 

The purpose of the stand-back provision is to ensure completeness of the auditor’s identification of transactions, account balances, and disclosures--the areas the auditor plans to audit. 

Scalability

The complexity of an entity’s activities and environment drive the scalability of applying SAS 145. 

Size and complexity do not necessarily correlate. Smaller entities tend to be less complex, but some are not--they are complex. Larger entities tend to be more complicated, but some are not. So consider the accounting system, the industry, the internal controls including information technology, and other factors in applying SAS 145. Complexity, not the entity’s size, determines how you use this standard. 

Some entities may lack formal internal control policies. Even so, such a system of internal controls can still be functional. Therefore, auditors can vet these informal controls with inquiries, observations, and inspection of documents. In other words, risk assessment works even in small entities with informal controls

The nature and extent of risk assessment procedures will vary depending upon the nature and circumstances of the entity. Therefore, auditors should exercise judgment in determining the nature and extent of risk assessment procedures. For example, risk assessment procedures can be less for a non-complex business with simple processes. In such a company, the auditor might have fewer inquiries to understand the business and fewer preliminary analytics. 

Audit procedures in an initial audit may be more extensive. After the initial audit period, the auditor can focus on changes since then. (Even so, auditors still need to annually review the design and implementation of key controls related to significant transaction classes, account balances, disclosures.)

Professional Skepticism

Understanding the entity and its environment, including its reporting framework, is a foundation for professional skepticism. Auditors determine the evidence needed for risk assessment in light of the entity’s nature and accounting system.

SAS 145 highlights the need for auditors to maintain professional skepticism during the engagement team discussion.

Professional skepticism allows the auditor to:

  • Appropriately deal with contradictory information
  • Evaluate the responses received from management and those charged with governance
  • Be alert to potential misstatement due to fraud or error
  • Consider audit evidence in light of the entity’s nature and circumstances

Professional skepticism is necessary for evaluating audit information in an unbiased manner, leading to better identification and assessment of risks of material misstatement.

Information Technology (IT) Controls

SAS 145 emphasizes IT controls as they affect the risk of material misstatement. The standard introduces a new term: risk arising from the use of IT. And it defines general IT controls

IT risks

So what IT controls are you to consider? Those that affect the risk of material misstatement at the assertion level. 

Here’s how I think about this: 

  1. Start with the risk of material misstatement at the assertion level
  2. Determine the IT applications that affect the assertion
  3. Review the general IT controls that affect the IT applications

IT Relevant Assertion Example

For example, say occurrence is a relevant assertion for expenses. Then you might consider an IT control that requires a three-way match for invoice processing; the software will not allow a disbursement without matching the invoice amount, the purchase order amount, and the quantity in the receiving document. In such a system, the IT application is the payables module in the software.

An example of a general control (see definition below) for this application is the password for access to the payables module.

Why is the general IT control (the password) important? If a password was not necessary, then anyone could process payments. And this affects the occurrence assertion.  

As the auditor performs a walkthrough for payables, she will (for example):

  1. Inspect the three-way match documents.
  2. Observe the payables module in use.
  3. Inspect the logical access records from IT, showing who has access to the payables module.
  4. Observe the entry of a password by a payables clerk. 

You don’t need to review all general controls, only those related to risks arising from the use of IT

Risk Arising from the Use of IT 

SAS 145 defines risk arising from the use of IT as:

Susceptibility of information-processing controls to ineffective design or operation, or risks to the integrity of information in the entity’s information system, due to ineffective design or operation of controls in the entity’s IT processes.

Lower IT Risk

Entities are less likely to be subject to risks arising from the use of IT when they:

  • Use stand-alone applications
  • Have low volumes of transactions
  • Have transactions supported by hard-copy documents

Higher IT Risks

Entities are more likely to be subject to risks arising from the use of IT when they:

  • Have interfaced applications
  • Have high volumes of transactions
  • Have applications that automatically initiate transactions

General IT Controls 

SAS 145 defines general IT controls as: 

Controls over the entity’s IT processes that support the continued proper operation of the IT environment, including the continued effective functioning of information-processing controls and the integrity of information in the entity’s information system.

Examples of general IT controls include firewalls, backup and restoration, intrusion detection, passwords, physical security, and antivirus protection. 

Increasing Complexity of Entities and Auditing

SAS 145 recognizes the increasing complexity of entities and auditing. It does so by highlighting audit methods and tools such as:

  • Remote observation of assets using drones or video cameras
  • Use of data analytics software and visualization techniques to identify risks of material misstatement
  • Performing risk assessment on large volumes of data, including analysis, recalculations, reperformance, and reconciliations

System of Internal Control

SAS 145 replaces the term internal control with system of internal control. It defines system of control as:

The system designed, implemented, and maintained by those charged with governance, management, and other personnel to provide reasonable assurance about the achievement of an entity’s objectives with regard to reliability of financial reporting, effectiveness and efficiency of operations, and compliance with applicable laws and regulations. For purposes of GAAS, the system of internal control consists of five interrelated components: 

i. Control environment 

ii. The entity’s risk assessment process 

iii. The entity’s process to monitor the system of internal control 

iv. The information system and communication 

v. Control activities

It appears the Auditing Standards Board is highlighting the holistic nature of internal controls by including all five of the COSO control elements

SAS 145 Documentation Requirements 

Auditors must document their evaluation of the design of identified controls and their determination of whether such controls were implemented

Additionally, auditors must document their rationale for significant judgments regarding identified and assessed risks of material misstatement. In other words, how did you identify a risk of material misstatement, and why did you assess it as you did?

What is the criterion for determining whether the risk assessment documentation is appropriate? As in the past, it’s whether an experienced auditor having no previous experience with the audit understands the nature, timing, and extent of the risk assessment procedures. So, document the rationale for your risk assessment work and your conclusions

Effective Date of SAS 145

SAS 145 is effective for audits of financial statements for periods ending on or after December 15, 2023.

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