Efficient Tests of Balances Series—No. 6: Assessing Risk by Account Classification vs. by Assertion
SAS No. 107 directs auditors to assess risk at the financial statement level and at the assertion level. Risks of material misstatement may affect individual financial statement assertions or an account classification as a whole. Audit responses must be designed to determine and eliminate any effects of such risks on the financial statements.
Evaluating risks for individual assertions in each account classification obviously takes more time than evaluating risk for the account classification as a whole. Most audit responses to risks of material misstatement provide evidence for evaluating all relevant assertions or, in other words, the account classification as a whole. Is it really necessary, then, to evaluate risk for each individual assertion?
To answer this question, let’s consider the accounts receivable classification. Relevant assertions are existence, valuation, occurrence and cutoff. Let’s consider the normal audit responses for high risk in each of these assertions.
Existence—High risk related to the existence assertion in accounts receivable often indicates the possibility of error or fraud in recorded accounts receivable and related sales account balances. A customary audit response to high risk is to decrease the lower limit of individually significant items and audit account balances above that limit 100% by sending positive confirmations and/or performing alternative procedures that include inspection of subsequent customer payments and the related sales documents.
Occurrence and Cutoff—High risk in these assertions may indicate the possibility of fictitious sales being recorded during the year (particularly during the last month) and overstatement of accounts receivable and sales resulting from an improper cutoff. Audit responses normally consist of decreasing the lower limit for individually significant items, inspecting support for these larger sales transactions during the year and for an extended period after the end of the reporting period.
Valuation—Tests of the adequacy of the allowance for doubtful accounts when risk is higher may consist of inspection of documentation and correspondence relating to more account balances outstanding for longer periods. Inspections of more subsequent collections, discussions with management and additional confirmations may be necessary to respond to these risks.
For larger reporting entities, duties may be segregated among more accounting personnel. In such cases, it may be appropriate to design audit responses for risks that relate to individual assertions that arise from the responsibilities and duties assigned to different individuals. For smaller entities, however, one or two individuals may be responsible for all accounting system procedures, thereby raising the risk of misstatement associated with the accounts receivable account classification to a higher level. In such cases, audit responses that provide sufficient substantive evidence for the account classifications as a whole will generally consist of the most reliable auditing procedures being performed more extensively as of the reporting date.
For smaller reporting entities, therefore, the risk associated with a limited number of accounting personnel will generally raise the risk to higher levels for all financial statement assertions in some account classifications. In such cases, then, it will not ordinarily be necessary to individually evaluate the risk relevant to individual assertions; audit time charges can be reduced by evaluating risk related the account classifications as a whole.
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