Week 1: Audit Demand and Audit Risk
Demand for Auditing
Demand
➢ Is constantly changing
➢ Demand for auditing is increasing nowadays.
Audit
➢ Why: improve information quality (used to be financial information)
➢ What: obtain sufficient and appropriate evidence
➢ How: Regulated context.
o Independent professional
o Professional standards
▪ ISAs/ISAEs/ISREs/ISRSs
o Ethical standards
We focus on ISAs (COS in Dutch) in this course.
We have regulation on the individual auditors and regulation on audit firms in the Netherlands.
An audit is an opinion by an independent auditor on whether financial statements are in all material
aspects present fairly in accordance with GAAP (IFRS, USGAAP, DAS)
➢ What does present fairly mean? → without bias, using XBRL in presenting is seen as fairly
present.
90% of all voluntary sustainability reporting claims get restated within one year.
Economics of Audit Demand
➢ Exogenous: demand by outside intervention. Supply-demand does not apply. There is no
equilibrium, demand is fixed.
➢ Endogenous: demand arises within the economy. It is a supply-demand model.
o Agency relation: transfer of decision-making power
o Agency theory: conflicts of interest… due to differences in incentives and information
asymmetry
▪ Moral hazard: agent actions not observed yet incentivized (work hard/shirk)
▪ Adverse selection: principle can’t observe the quality of the firm (lemon).
Endogenous: independent audit reduces incentive problems of the manager and should exist in
earliest firms
Exogenous: audit textbooks: recent product of government intervention
Professional behavior
➢ Historically
o Unregulated
o Fine and reputation effect (when auditors do not perform well, there is a fine and
reputation loss)
, ➢ Today
o Regulated
o Independence
o [fine and reputation] → nowadays not crucial anymore.
Audit (fraud) Risk
Risk
➢ Business risk: threat to an organization not meeting objectives
➢ Audit risk: inappropriate audit opinion (type-2 error: 5%, audit firms accept this risk)
Insurance companies set this at 100%.
➢ Engagement risk: litigation, reputation, profitability
Response to risk
Audit risk
Total misstatement – ‘Caught’ by internal control – ‘caught’ by auditor = undetected misstatement
Inherent risk (IR) Control Risk (CR) Detection risk (DR) Audit risk (AR)
Detection risk (DR): risk that auditor will not detect a material misstatement
Audit Risk (AR): Risk that auditor expresses inappropriate opinion
Audit risk model
➢ Inherent Risk: Understand the business
➢ Internal control risk: Understand and assess controls
➢ Detection risk: auditor response
Paper Houston et al 1999
➢ RQ: identify conditions under which the audit risk model does (not) describe audit planning
and pricing
➢ Audit risk = RMM
➢ Audit business risk = risk of loss to and auditor’s due to client relationships (a.k.a.
engagement risk)
o Litigation risk
o Regulatory penalties
o Reputation loss
o Lack of profitability
,Conclusions
➢ Likelihood of error high:
o When audit risk model dominates business risk
o No risk premium
➢ Likelihood of irregularity high:
o Business risk model dominates audit risk model
o Risk premium
➢ Irregularity standard (ISA 240) is incomplete (this is their conclusion)
Paper Yew-Low
➢ RQ: effect of industry specialization on audit risk assessment and audit planning?
➢ Industry-matched auditors…
o H1: better discern audit risks
o H2: more procedure changes
o H3: procedure changes more sensitive to risk assessment
o H4: procedure changes have higher perceived quality
Conclusion
➢ Industry experience
o Affects modification of audit procedures
o Modifications have higher quality
Intentional misstatements
➢ Fraudulent reporting
➢ Misappropriation of assets
Fraud Triangle
, The only thing you have to remember from the paper, are the following triangles:
Fraud response
Auditor responsibility (very important slide)
➢ The primary responsibility for the prevention and detection of fraud rests with both those
charged with governance of the entity and management
➢ Secondary responsibility : “The auditor should obtain an understanding of the entity and its
environment, including its internal control, sufficient to identify and assess the risks of
material misstatement of the financial statements whether due to fraud or error, and
sufficient to design and perform further audit procedures” (ISA 315)
Week 2: Building blocks part 2
Materiality
The magnitude of an omission or misstatement of accounting information that makes it probable
that the judgment of a reasonable person relying on the information would have been changed or
influenced.
➢ Decision usefulness of information
➢ User perspective
➢ Not the same as materiality in accounting standards!
Who sets the materiality for the financial statement? Management
Who sets the materiality in accounting standards? Auditors
Overall materiality versus performance materiality
Demand for Auditing
Demand
➢ Is constantly changing
➢ Demand for auditing is increasing nowadays.
Audit
➢ Why: improve information quality (used to be financial information)
➢ What: obtain sufficient and appropriate evidence
➢ How: Regulated context.
o Independent professional
o Professional standards
▪ ISAs/ISAEs/ISREs/ISRSs
o Ethical standards
We focus on ISAs (COS in Dutch) in this course.
We have regulation on the individual auditors and regulation on audit firms in the Netherlands.
An audit is an opinion by an independent auditor on whether financial statements are in all material
aspects present fairly in accordance with GAAP (IFRS, USGAAP, DAS)
➢ What does present fairly mean? → without bias, using XBRL in presenting is seen as fairly
present.
90% of all voluntary sustainability reporting claims get restated within one year.
Economics of Audit Demand
➢ Exogenous: demand by outside intervention. Supply-demand does not apply. There is no
equilibrium, demand is fixed.
➢ Endogenous: demand arises within the economy. It is a supply-demand model.
o Agency relation: transfer of decision-making power
o Agency theory: conflicts of interest… due to differences in incentives and information
asymmetry
▪ Moral hazard: agent actions not observed yet incentivized (work hard/shirk)
▪ Adverse selection: principle can’t observe the quality of the firm (lemon).
Endogenous: independent audit reduces incentive problems of the manager and should exist in
earliest firms
Exogenous: audit textbooks: recent product of government intervention
Professional behavior
➢ Historically
o Unregulated
o Fine and reputation effect (when auditors do not perform well, there is a fine and
reputation loss)
, ➢ Today
o Regulated
o Independence
o [fine and reputation] → nowadays not crucial anymore.
Audit (fraud) Risk
Risk
➢ Business risk: threat to an organization not meeting objectives
➢ Audit risk: inappropriate audit opinion (type-2 error: 5%, audit firms accept this risk)
Insurance companies set this at 100%.
➢ Engagement risk: litigation, reputation, profitability
Response to risk
Audit risk
Total misstatement – ‘Caught’ by internal control – ‘caught’ by auditor = undetected misstatement
Inherent risk (IR) Control Risk (CR) Detection risk (DR) Audit risk (AR)
Detection risk (DR): risk that auditor will not detect a material misstatement
Audit Risk (AR): Risk that auditor expresses inappropriate opinion
Audit risk model
➢ Inherent Risk: Understand the business
➢ Internal control risk: Understand and assess controls
➢ Detection risk: auditor response
Paper Houston et al 1999
➢ RQ: identify conditions under which the audit risk model does (not) describe audit planning
and pricing
➢ Audit risk = RMM
➢ Audit business risk = risk of loss to and auditor’s due to client relationships (a.k.a.
engagement risk)
o Litigation risk
o Regulatory penalties
o Reputation loss
o Lack of profitability
,Conclusions
➢ Likelihood of error high:
o When audit risk model dominates business risk
o No risk premium
➢ Likelihood of irregularity high:
o Business risk model dominates audit risk model
o Risk premium
➢ Irregularity standard (ISA 240) is incomplete (this is their conclusion)
Paper Yew-Low
➢ RQ: effect of industry specialization on audit risk assessment and audit planning?
➢ Industry-matched auditors…
o H1: better discern audit risks
o H2: more procedure changes
o H3: procedure changes more sensitive to risk assessment
o H4: procedure changes have higher perceived quality
Conclusion
➢ Industry experience
o Affects modification of audit procedures
o Modifications have higher quality
Intentional misstatements
➢ Fraudulent reporting
➢ Misappropriation of assets
Fraud Triangle
, The only thing you have to remember from the paper, are the following triangles:
Fraud response
Auditor responsibility (very important slide)
➢ The primary responsibility for the prevention and detection of fraud rests with both those
charged with governance of the entity and management
➢ Secondary responsibility : “The auditor should obtain an understanding of the entity and its
environment, including its internal control, sufficient to identify and assess the risks of
material misstatement of the financial statements whether due to fraud or error, and
sufficient to design and perform further audit procedures” (ISA 315)
Week 2: Building blocks part 2
Materiality
The magnitude of an omission or misstatement of accounting information that makes it probable
that the judgment of a reasonable person relying on the information would have been changed or
influenced.
➢ Decision usefulness of information
➢ User perspective
➢ Not the same as materiality in accounting standards!
Who sets the materiality for the financial statement? Management
Who sets the materiality in accounting standards? Auditors
Overall materiality versus performance materiality
