Can you identify Significant Risks for an audit client?

Summary

In this educational video, Dr. Amanda White clarifies the confusion between business risks, inherent risks, control risks, and the risk of material misstatement, which often leads to lost marks in exams. She explains the concept of significant risks, as defined by ISA 315, and provides three practical tips to help identify them. These tips include understanding the client's industry and operations, distinguishing between business and inherent risks, and linking risks to potential misstatements. The video aims to help students excel in their auditing assessments and exams.

Takeaways

• 📚 Dr. Amanda White discusses the confusion students face between business risks, inherent risks, control risks, and the risk of material misstatement.
• 🔍 The video aims to untangle these concepts and provide tips for identifying significant risks, which are crucial for planning and executing audits.
• 📈 Significant risks are defined as the risk of material misstatement or error that could affect the audit process, originating from ISA 315.
• 🌐 Inherent risks are linked to the nature of the client's operations, such as trading in foreign currencies or having complex bonus schemes.
• 🛠 Control risks arise when internal controls are missing or not functioning properly, increasing the chance of misstatement or error.
• 📝 The new ASA 315, effective in 2021, instructs auditors to identify risks of material misstatement and evaluate their potential impact and likelihood.
• 🧠 Tip 1: Understanding the client is key to identifying inherent risks; this includes knowledge of their industry, operations, corporate governance, and global economic context.
• 🚫 Tip 2: Business risks are not always inherent risks; they may not necessarily lead to increased accounting errors or misstatements.
• 🔗 Tip 3: Ensure risks can be linked to an account or assertion; if not, they may not be significant risks.
• 💡 The ability to identify significant risks is foundational to auditing, as failure to do so could lead to undetected material misstatements and incorrect audit opinions.

Q & A

What is the main topic discussed in Dr. Amanda White's video?

The main topic discussed is the concept of significant risks in auditing, particularly the confusion between business risks, inherent risks, control risks, and the risk of material misstatement.

What are the two main sources of risk of misstatement or error in financial statements according to the video?

The two main sources are inherent risks and control risks. Inherent risks are due to the nature of the business or industry, while control risks are due to the absence or ineffectiveness of internal controls.

What does the term 'inherent risk' mean in the context of auditing?

Inherent risk refers to the risk of misstatement or error that exists due to the nature of the client's business or industry, which is a permanent or characteristic attribute of the client.

How does the new AS 31:5 standard mentioned in the video help in identifying significant risks?

The new AS 31:5 standard instructs auditors to identify risks of material misstatement and then consider their broad financial statement impact and evaluate the nature and extent of their effect, helping to distinguish significant risks.

What are Dr. Amanda White's three tips for identifying significant risks?

Tip one is to know the client well, including their industry, operations, corporate governance, and global economic environment. Tip two is to distinguish between business risks and inherent risks. Tip three is to ensure the risk can be linked to an account or assertion to increase the risk of misstatement or error.

Why is it important to differentiate between business risks and inherent risks?

Differentiating between business risks and inherent risks is important because not all business risks result in an increase in the risk of misstatement or error in accounting, and this distinction helps in accurately identifying significant risks.

What is the significance of understanding the client's industry in identifying inherent risks?

Understanding the client's industry helps in identifying where potential mistakes or errors in accounting might occur, as certain industries may have unique or complex accounting policies that increase inherent risk.

How does the global economic environment factor into the identification of inherent risks?

The global economic environment can introduce risks such as trade tensions, disruptions due to technological advancements, or difficulties in refinancing debts, which can affect a client's operations and thus increase inherent risks.

What is the consequence of not properly identifying significant risks during an audit?

Failing to properly identify significant risks can lead to missing a material misstatement, providing an incorrect audit opinion, and potentially facing legal consequences such as lawsuits.

What is the call to action at the end of the video for viewers to engage with the content?

The call to action is for viewers to select one of the companies - Apple, Airbnb, or Innisfree - and identify three significant risks they believe the company faces, then share their risks and explanations in the comments section.

Outlines

00:00

📚 Understanding Significant Risks in Auditing

Dr. Amanda White introduces the concept of significant risks in auditing, highlighting the confusion students often face between business risks, inherent risks, control risks, and the risk of material misstatement. She aims to clarify these terms and provide tips for identifying significant risks. The video is divided into two parts: the first part focuses on untangling the term 'significant risk,' and the second offers three tips to master the concept. Dr. White explains that significant risks are derived from ISA 315 and pertain to the risk of material misstatement or error that could affect the audit planning and execution. She emphasizes the importance of distinguishing between inherent and control risks, with inherent risks being characteristics of the client that increase the risk of misstatement or error. The video also discusses the upcoming changes in ISA 315 and how they will help auditors identify and evaluate significant risks based on their potential impact and likelihood of occurrence.

05:01

🌐 Analyzing Inherent Risks and Business Risks

In the second paragraph, Dr. White delves into the specifics of inherent risks, explaining that they are often misunderstood as being the same as business risks. She clarifies that business risks are challenges faced by management that do not necessarily lead to accounting errors, while inherent risks are more about the potential for mistakes in financial reporting due to the nature of the client's operations. Dr. White provides examples to illustrate the difference, such as the focus of mining firm CEOs on geological surveys rather than accounting issues. She stresses the importance of separating business risks from inherent risks and offers a third tip: to ensure that identified risks can be linked to an account or assertion to be considered significant. She uses the example of competition and sales incentives to demonstrate how certain risks can directly impact the financial statements. Dr. White concludes by emphasizing the foundational role of identifying significant risks in conducting a successful audit and encourages viewers to apply her tips to real-world companies like Apple, Airbnb, or Innisfree to practice identifying significant risks.

Keywords

💡Significant Risks

Significant risks refer to the risks of material misstatement in financial statements that are likely to affect the planning and execution of an audit. In the video, Dr. Amanda White emphasizes the importance of distinguishing significant risks from other types of risks. These risks are crucial for auditors to identify as they form the basis of the audit process and can impact the overall audit opinion. For instance, the video discusses how inherent risks, if material, can be considered significant risks.

💡Inherent Risks

Inherent risks are the risks of misstatement or error in financial statements that arise from the nature of a company's operations. The video uses the example of a company trading overseas in foreign currencies, which inherently increases the risk of errors in foreign currency translation. These risks are considered inherent because they are a permanent and essential attribute of the client's business operations.

💡Control Risks

Control risks are associated with the possibility that a company's internal controls may be missing or not functioning as they should, leading to misstatements in financial reporting. The video explains that these risks are distinct from inherent risks and are related to the effectiveness of the company's control environment. An example given is a bonus plan based on sales levels, which might lead to fraudulent manipulation by salespeople.

💡Material Misstatement

Material misstatement is an error or omission in financial statements that could significantly affect the decisions of users relying on that information. The video discusses how significant risks are directly linked to the risk of material misstatement, which auditors must identify and assess during the audit process. It is a key concept because it determines the scope and depth of the audit work.

💡Audit Planning

Audit planning involves the strategies and procedures that auditors undertake to ensure that the audit is conducted efficiently and effectively. In the context of the video, understanding and identifying significant risks is a critical part of audit planning because it influences the nature, timing, and extent of audit procedures.

💡ISA 315

ISA 315 is an International Standard on Auditing that pertains to the auditor's responsibility to understand the client and its environment, including its internal control. The video mentions that ISA 315 is a key standard that guides auditors in identifying inherent and control risks, and it will be updated in 2021 to provide more detailed guidance on assessing significant risks.

💡Business Risks

Business risks are the potential events or circumstances that could negatively impact a company's ability to achieve its business objectives. The video clarifies that not all business risks are inherent risks, and it is important for auditors to differentiate between the two. An example provided is the geological surveys that a mining firm CEO might be interested in, which are business risks but not necessarily accounting risks.

💡Global Economic Environment

The global economic environment refers to the broader economic context in which a company operates, including factors such as trade tensions, market conditions, and technological disruptions. The video uses the example of Thomas Cook to illustrate how changes in the global economic environment can create inherent risks for a company, such as the inability to refinance debts due to changes in consumer behavior and market dynamics.

💡Accounting Policies

Accounting policies are the specific principles, bases, conventions, rules, and procedures applied by an entity in preparing and presenting financial statements. The video discusses how certain industries may have unique or complex accounting policies that can increase the inherent risk of misstatement, such as how pharmaceutical companies account for R&D costs or how mining companies value natural resources.

💡Assertions

Assertions in auditing refer to the representations by management that are embodied in the financial statements, such as the existence, completeness, accuracy, and valuation of assets and liabilities. The video explains that auditors must link identified risks to specific assertions to determine their significance. For example, if there is a risk related to sales revenue due to salespeople's incentives, it directly affects the assertion of completeness and accuracy of sales figures.

Highlights

Dr. Amanda White discusses the confusion between business risks, inherent risks, control risks, and the risk of material misstatement.

Provides three tips to help identify significant risks for students.

Explains the term 'significant risk' from ISA 315 and its importance in the audit process.

Differentiates between inherent and control risks, emphasizing their distinct nature.

Describes inherent risks as characteristics that increase the risk of misstatement or error.

Mentions the upcoming changes in ISA 315 in 2021 that will provide more detailed guidance on identifying significant risks.

Outlines the process of brainstorming potential inherent risks and evaluating them for potential impact and likelihood of occurrence.

Emphasizes the importance of knowing the client to identify where potential accounting errors might occur.

Discusses the role of industry-specific accounting policies in identifying inherent risks.

Highlights the need to understand the client's operations to identify risks associated with transactions and valuations.

Explains how the global economic environment can influence the inherent risks of a client.

Clarifies that business risks are not always inherent risks and should be separated for accurate risk assessment.

Advises on linking risks to accounts or assertions to determine their significance.

Stresses the foundational role of identifying significant risks in the audit process to avoid material misstatement.

Encourages students to apply the three tips to identify significant risks for companies like Apple, Airbnb, or Innisfree.

Invites students to share their risk assessments in the comments for further discussion.

Reminds viewers of the importance of understanding significant risks to prevent legal issues such as lawsuits for wrong audit opinions.

Transcripts

what's up what it fans dr. Amanda white

here and today we're going to talk about

significant risks now students are often

confused between business risks inherent

risks controllers significant risks and

the risk of material misstatement and

this results in a lot of lost marks in

ordered exams today I'm going to

untangle these concepts and give you

three tips to help you identify

significant risks so let's get into it

[Music]

a big welcome back to all my regular

subscribers and hi if you're new to the

channel my name is Amanda I'm a former

auditor I've got a PhD in behavioral

auditing and I teach auditing at

university here in Australia now today's

video is in two parts part one is

untangling the term significant risk and

part two will be my three tips to help

you become a significant risk master the

term significant risk comes from a si is

a three one five about understanding the

client and it really means what is the

risk of misstatement or error this

material and likely to affect the

planning and the execution of the audit

but what does that mean in plain English

where do I find these risks how do i

generate them for my standards well we

need to start with sources of risk of

misstatement or error in the financial

statements and there are really two main

ones either from areas that are more

risky because of their nature all

because internal controls are missing or

not working appropriately now these two

sorts of risks are called inherent and

control risks and it's important to be

able to distinguish between them the

word inherent is in the clue here the

definition of inherent according to the

Oxford English Dictionary is existing in

something as a permanent essential or

characteristic attribute so that really

means some characteristic of the client

increases the risk of misstatement or

error for example if you trade overseas

in foreign currencies there's a much

greater risk of making a mistake in your

foreign currency translation reserve if

you have a bonus plan based on the level

of sales you may have fraudulent

manipulation by salespeople for

companies that have lots of subsidiaries

then there's a greater chance of making

a mistake when you're consolidating all

of those subsidiaries double-whammy if

you're also got subsidiaries in

different countries so you might be

thinking inherent risks are significant

risks right and you'd sort of be correct

and this is where things get a little

bit complicated in 2021 new a sa 31:5

will come into force it's more detailed

than what we see right now but it's

actually going to help us understand and

unpick this situation paragraph 45

instructs auditors to identify

because of material misstatement and

then do two things number one consider

whether they have a broad financial

statement impact or an impact on just a

small part of the accounts or assertions

number two evaluate the nature and

extent of their effect that is what is

the potential impact and what's the

possibility or likelihood of occurring

so how exactly does that help us well it

means that we need to brainstorm all of

the potential inherent risks for the

client then we're going to need to

evaluate them against their potential

impact and the likelihood of occurrence

and link them to an account or an

assertion our highest ranking risks will

become our significant ones now I know

your next question is going to be well

how do I actually generate this list of

inherent risks that will then become my

significant risks well this is where my

three tips are going to come into play

tip number one we start by knowing our

client and that's the whole point of

three one five know the client their

industry their operations their

corporate governance the company and how

it fits within the global economic

environment once you know your client

you'll be able to identify where the

potential mistakes or errors in the

accounting might occur the exact areas

that a SI 3 1 5 requires you to

understand about the client can actually

be used to help structure your analysis

for example industry are their

accounting policies within that industry

that are unique or excessively

complicated for example pharmaceutical

companies and their R&D costs and how

they could be accounted for mining

companies have real difficulties in

valuing natural resources stuck in the

ground we also need to know about the

operations of the client are they

multinational do they use foreign

currencies do they use hedges do they

have an increased risk of using the

wrong rate or making a calculation

mistake they're due to the volume of

their transactions clients that have

lots of intangible assets have an

increased risk around the valuation and

impairment of those assets if management

received big bonuses linked to key

performance indicators then they're more

likely to manipulate those indicators

and those accounts become greater at

risk we also need to think about the

global environment

if you're an American come

that deals with China then there may be

some risk due to trade tensions between

the cup two countries if they can't get

the supplies or products they need that

could be an issue of going concern

another example might be when a client

is trying to refinance their debts we

saw that in Thomas Cook the global

economy had moved on from traditional

travel agencies and the internet

disrupted their business they weren't

able to refinance and restructure now

these are a few types of different

inherent risks but there are endless

possibilities depending on the industry

and the company and you can only

generate them by understanding the

client really well now tip number two is

that business risks are not always

inherent risks business risks are those

faced by management things aren't going

to stop them from achieving their

business objectives and they don't

necessarily result in an increase in a

mistake or an error in the accounting an

example might be in the mining firms

mining firms CEOs aren't really

interested in the accounting issues

around exploration and development costs

they are interested in what do the

geological survey say about where the

next places to dig so we need to make

sure that we separate our business risks

and inherent risks this is really really

important some will cross over but quite

often they don't tip number three see if

you can explain why your risk increases

the risk of misstatement or error if you

can't link the risk to an account or an

assertion then it's not likely to be a

good risk now an example here is

competition if you can't explain why

competition in your industry for your

client increases the possibility of

error or manipulation then it's not a

risk if salespeople received a bonus of

60% related to their monthly sales

targets then boom you've got a clear

risk because there's cause and effect

the incentive structure will cause or

incentivize salespeople to manipulate

the accounts and that's going to affect

sales revenue commissions with the

occurrence and cutoff assertions now

identifying the important significant

risks is the foundation of the audit if

you don't identify the risks properly at

the

of the audit then you risk missing out

on detecting a material misstatement and

giving the wrong opinion and of course

nobody wants to get sued for giving the

wrong opinion so now it's over to you

select one of the following three

companies Apple Airbnb or Innisfree and

see if you can identify three risks that

you would think would fall under the

significant risk category put your risks

and your explanations for why you think

there are risks in the comments in a

later video I'll share my analysis my

answers and also your responses

I hope my three tips will help you

identify significant risks and stop you

from getting caught out and losing marks

in your exams and assessments as always

I'd appreciate a thumbs up on the video

if you haven't already please consider

subscribing to the channel and you can

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Instagram where I post and chat daily

otherwise I'll see you next time