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    Misstatements in Financial Statements: The Relationship...
    research summary posted March 1, 2015 by Jennifer M Mueller-Phillips, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.05 Assessing Risk of Material Misstatement, 09.0 Auditor Judgment, 09.01 Audit Scope and Materiality Judgments 
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    Title:
    Misstatements in Financial Statements: The Relationship between Inherent and Control Risk Factors and Audit Adjustments
    Practical Implications:

    The findings provide support for the relationships between inherent and control risk factors and misstatements as proposed by the audit risk model. Our results are informative to audit standard setters and audit firms in designing and structuring their audit approaches, especially the audit manual or the corresponding requirements embedded in firm-specific IT-tools. The findings suggest that an auditor should consider entity-level controls, because the strength of these controls appears to be particularly associated with misstatements. Considering an explicit requirement for auditors to identify, assess, and evaluate entity-level controls would make sense. Additionally, the findings suggest developing additional guidance on the effectiveness of an internal audit department and on whether using the opinions reached in a client’s internal audit. Finally, the findings demonstrate the usefulness of audits. 

    Citation:

    Ruhnke, K. and M. Schmidt. 2014. Misstatements in financial statements: The relationship between inherent and control risk factors and audit adjustments. Auditing: A Journal of Practice and Theory 33 (4): 247–269

    Keywords:
    Audit adjustments, audit risk model, business risk audit approach, International Standards on Auditing (ISA), materiality
    Purpose of the Study:

    The authors analyze whether audit adjustments detected in the course of an audit vary systematically with inherent and control risk factors. Because the audit risk model also proposes these relationships, our analysis has a bearing on the empirical validity of the risk model. Audit adjustments also provide evidence of the usefulness of audits in general.

    Design/Method/ Approach:

    The analysis is based on proprietary data from a large sample of audit adjustments detected in 255 financial statement audits in 2007 conducted by a Big 4 audit firm in Germany. The authors use a series of multivariate regression analyses to study the association between inherent and control risk factors and the number and magnitude of audit adjustments. Client specific planning materiality is incorporated into the design by scaling the absolute magnitude of adjustments by materiality (magnitude of the adjustments relative to client specific materiality). The analyses control for other factors, such as tenure, GAAP, and audit input.

    Findings:

    The mean size of the audit adjustments is 8.5 times larger, and the income-affecting adjustments are 5.0 times larger, than the client specific planning materiality threshold as set by the audit firm. This finding constitutes strong evidence of the corrective function of audits and the usefulness of audits in general.

    Our findings show that audit adjustments vary systematically with inherent and control risk factors, as proposed by the audit risk model. Specifically, we find that the following risk factors (corresponding to variables in the model) have a significant effect on audit adjustments:

    • Inherent risk factors: The number and relative magnitude of audit adjustments, particularly income-affecting adjustments, is lower if the quality of a client’s management (integrity and competence) is higher or the client’s financial position is stronger.
    • Control risk factors: The relative magnitude of audit adjustments is lower if entity-level controls are stronger or if the entity has an effective internal audit function. The number of adjustments is lower if the internal control system is overall stronger.

    Our results are consistent with evidence from the audit quality literature suggesting an auditor’s ability to detect misstatements is lower in the initial years of an engagements but then increases for a certain period of time. 

    Category:
    Auditor Judgment, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Assessing Risk of Material Misstatement, Audit Scope & Materiality Judgements