Engagement Risk

Audit Theory and Practice

7 Sept 202002:01

Summary

TLDRThe auditor must evaluate various risk factors when considering a new client, such as the client's financial stability, economic climate, and business model. They also assess the likelihood of financial reporting errors and the potential impact of restatements. The audit firm considers the client's location, internal controls, and the firm's own resources and independence. The audit risk determines the fees charged, which in turn affects the audit quality. Independence is crucial, and if lacking, the engagement cannot proceed.

Takeaways

🔍 Auditors must consider various risk factors beyond the auto-risk model when accepting a new client.
💼 The client's ability to survive economically is crucial for the auditor as it impacts bill payments and the firm's reputation.
🌐 Evaluating the economic climate, technological impact, competition, business development, and geographic location is essential for risk assessment.
🏢 The client's business model and the audit firm's business risks are intertwined, affecting the decision to accept the client.
💡 Financial reporting risk involves assessing the likelihood of overstatement and the potential impact of a restatement.
🔑 Integrity, incentives, and internal controls of the client are critical factors in determining the quality of the company and the audit engagement.
💼 The audit firm seeks to associate with high-quality companies to ensure mutual benefits from the audit engagement.
💵 Audit fees are determined based on the assessed audit risk, which in turn influences the resources allocated to the audit.
⚖️ Independence is a non-negotiable requirement for auditors; lacking it disqualifies the firm from accepting the engagement.
🛠️ Competence can be addressed through hiring new personnel or using specialists, but independence issues cannot be resolved.

Q & A

What are the typical risk factors an auditor considers when accepting a new client?
-The auditor considers factors beyond the auto-risk model, including the client's business viability, economic survival, and the potential for bankruptcy which could affect the audit firm's reputation.
Why is the client's ability to survive economically important to the audit firm?
-The client's economic survival is important because it ensures they can pay the bills, and bankruptcy could lead to reputational damage for the audit firm.
What external factors might an auditor consider when evaluating a client's business?
-The auditor might consider the economic climate, technological impact, competition, business model, and geographic location of the client's operations.
How does the geographic location of the client and audit firm affect the audit engagement?
-If the client and audit firm are not in the same geographic region, it could introduce additional business risks, potentially making them a poor fit for each other.
What is financial reporting risk and why is it important in the audit process?
-Financial reporting risk refers to the likelihood of overstatement in financial reports and the potential impact of restatements. It's important because it helps the auditor assess the quality of the client's financial reporting.
What factors does an auditor consider when determining the complexity of a client's financial reporting?
-An auditor considers the client's integrity, incentives, and internal controls to assess the complexity of financial reporting.
Why is it beneficial for an audit firm to associate with high-quality companies?
-Associating with high-quality companies that do good work benefits everyone involved, as it enhances the reputation of the audit firm and ensures a more successful audit process.
How does the audit firm determine the audit fees to charge a client?
-The audit firm determines the audit fees based on the assessed audit risk, which in turn affects the resources allocated to the audit engagement.
What questions does an audit firm ask regarding the availability of resources for an audit?
-The audit firm asks whether the client can provide sufficient resources for the audit, as the lack of resources could make the firm and client a poor fit.
Why is independence necessary for an audit firm to engage in an audit?
-Independence is necessary to ensure the objectivity and integrity of the audit process. Without independence, the audit firm cannot accept the engagement.
How can an audit firm address a lack of competence in handling an audit engagement?
-An audit firm can address a lack of competence by using specialists or hiring new personnel to gain the necessary expertise.
Is it possible for an audit firm to address a lack of independence?
-Lacking independence cannot be addressed, as it is a fundamental requirement for the audit firm to perform an audit.

Outlines

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🔍 Client Acceptance and Risk Assessment

The auditor must consider various risk factors when accepting a new client, beyond the standard auto-risk model. These factors include the client's ability to survive economically, which is crucial for the audit firm's revenue. Additionally, the client's bankruptcy could lead to reputational damage for the firm. The auditor also evaluates the economic climate, technological impact, competition, industry development, business model, and geographical location of the client. These factors influence the audit firm's decision on whether to engage with the client. The financial reporting risk is assessed by estimating the likelihood of overstatement and the potential impact of a restatement. The auditor seeks to associate with high-quality companies to ensure mutual benefits. The engagement risk is determined by combining the business risk and financial reporting risk. Once the audit risk is assessed, the audit fees are set, which affects the resources allocated to the audit. The client's willingness to provide sufficient resources is a determining factor for the audit firm's engagement. The firm also questions its independence at the outset and may need to address any lack of competence or independence, with the latter being a non-negotiable aspect.

Mindmap

Keywords

💡Risk factors

Risk factors refer to the various elements that could potentially lead to negative outcomes or uncertainties. In the context of the video, these are the elements an auditor must consider before accepting a new client, such as the client's ability to survive economically and the potential for reputational damage if the client goes bankrupt. The video emphasizes the importance of evaluating these factors to mitigate the risks associated with taking on a new client.

💡Auto-risk model

The auto-risk model is a tool or framework used by auditors to assess the risks associated with a client. It is mentioned as an example of the typical factors considered beyond the standard ones. The model likely involves analyzing data and financial information to predict the likelihood of certain risks, such as the client's financial stability and the potential for errors in financial reporting.

💡Economic climate

The economic climate refers to the overall state of the economy, including factors like market trends, inflation, and economic growth. In the video, it is one of the factors auditors consider when assessing a client's business risk. A challenging economic climate could increase the risk that a client may not survive economically, which is crucial for the audit firm as it affects their ability to receive payment and maintain a positive reputation.

💡Technology impact

Technology impact pertains to how technological advancements and changes affect a company's operations and industry. The video suggests that auditors must consider this when evaluating a client, as technology can significantly influence a company's competitiveness and business model. For instance, a client in a tech-driven industry might face unique risks related to rapid innovation and obsolescence.

💡Competition

Competition refers to the rivalry among businesses within the same market or industry. In the script, it is highlighted as a factor that auditors examine when assessing a client's business risk. A client with intense competition may face greater challenges in maintaining profitability and market share, which could indirectly affect the audit firm's risk profile.

💡Business model

A business model outlines how a company creates, delivers, and captures value. The video emphasizes the importance of understanding a client's business model as part of the risk assessment process. A robust and adaptable business model can indicate a lower risk of economic failure, which is beneficial for the audit firm both financially and in terms of reputation.

💡Geographic region

Geographic region refers to the physical location or area where a business operates. The video mentions that if a client and an audit firm are not in the same geographic region, it could present business risks for the firm. This could include logistical challenges, cultural differences, or legal and regulatory complexities that might affect the audit process.

💡Financial reporting risk

Financial reporting risk is the possibility of inaccurate or misleading information in a company's financial statements. The video discusses how auditors assess this risk by considering the likelihood of overstatement and the potential impact of a restatement. This is critical as it directly relates to the audit firm's responsibility to ensure the accuracy and integrity of financial reports.

💡Audit fees

Audit fees are the charges that a client pays to an audit firm for their services. In the context of the video, these fees are important as they determine the resources the firm can allocate to an audit. If a client is unwilling or unable to provide sufficient fees, it could limit the audit firm's ability to conduct a thorough audit, which might lead to a decision not to accept the engagement.

💡Independence

Independence in auditing refers to the auditor's ability to remain objective and free from conflicts of interest. The video stresses that auditors must have independence to accept an engagement. If there is a lack of independence, it could compromise the integrity of the audit and lead to a decision not to proceed with the client, as independence is a fundamental requirement for audits.

💡Competence

Competence in the auditing context means having the necessary skills, knowledge, and expertise to perform an audit effectively. The video mentions that if an audit firm lacks the required competence, they might need to hire new personnel or use specialists to address the gap. Competence is essential for delivering high-quality audits and maintaining the firm's reputation.

Highlights

Auditors must consider various risk factors beyond the auto-risk model when accepting a new client.

The client's ability to survive economically is crucial for the audit firm.

Bankrupt clients can cause reputational damage to the audit firm.

Economic climate and technological impact are factors considered in client assessment.

Competition, development, and business model of the client are important for the audit firm.

Geographic location of the client and firm can influence the business fit.

Financial reporting risk involves the likelihood of overstatement and potential restatement.

Complexity of the client, integrity, and internal controls are assessed for audit risk.

Audit firms prefer to associate with high-quality companies for mutual benefit.

Engagement risk is determined by combining business and financial reporting risks.

Audit risk assessment influences the audit fees charged to the client.

Sufficient resources from the client are necessary for a successful audit.

Audit firms must ensure independence before engaging in an audit.

Lack of independence is a deal-breaker for audit engagements.

Competence can be addressed by hiring specialists or new personnel.

Independence issues are non-negotiable and cannot be resolved post-acceptance.