Research School of Accounting

INDIVIDUAL ASSESSMENT COVER SHEET

Student Name:

SAUR MARULI

Student ID No:

U5542016

Course Code:

BUSN7054 Auditng & Assurance Services

Tutors name:

Alicia Jiang

Tutorial Day/Time:

Monday / 10.00 11.00

Assignment No:

Topic:

Learning Journal 1

Word Count:

25 September 2015

_ Date Submitted: 25 September 2015

Due Date:

I hereby confirm that the work contained in this assignment is solely my own, except for
reliance on material that is identified and cited according to accepted academic practice. I
have read and understood the ANUs Code of Practice for Student Academic Honesty.

Signed:

Date: 25 September 2015

| ANU COLLEGE OF BUSINESS AND ECONOMICS

Learning Journal

Misstatement in Financial Statements:

The Relationship between Inherent and Control Risk Factors and
Audit Adjustments


Theoretical Background

Types of Risk

To give an assurance to stakeholders, auditors are required conduct an audit of financial
statements to detect any material misstatements that might be caused by human errors
or frauds. In doing so, the auditors must first of all identify and assess risk of material
misstatements that may occur. Furthermore, according to what we have learnt
especially in lecture 4 & 5, risk of material misstatements at both the financial record
and assertion levels can be caused by two types of risk namely inherent risk and control
risk. Besides the inherent and control risk, auditors also acknowledge two other types
of risks namely detection risk and audit risk.

Figure 1
The Relationship among the Risks

















To further understand the risks we have mentioned above, we need to elaborate the
definitions of the risks as follows:

Inherent risk is susceptibility of account balance of class of transactions to material
misstatements given inherent and environmental characteristics, but without regard to
internal control. Control risk is the risk that a material misstatement could occur in an
assertion and not be prevented or detected on a timely basis by the entitys internal
control. Detection risk is the risk that the auditors will conclude that no material
errors are present when in fact there are. The auditors can decrease/increase the
detection risk by performing more/less substantive tests or collecting more/less audit
evidence. Audit risk is the overall risk that the auditors will not discover errors or

intentional miscalculation while reviewing a company or individual financial

statements. Basically, auditors can decide the audit risk they want to achieve by
controlling the detection risk by decreasing or increasing the substantive tests and
audit evidence.

As depicted in Figure 1, the inherent risk is the first tier of all risks. It relates to
environmental characteristics of a business entity such as the integrity and competence
of the clients management. It is expected that the more integrity and competence that
clients management has, the more inherent risk can be reduced to prevent any material
misstatements. All inherent risks are supposed to be prevented or filtered by the client
internal control. Failure to detect any material misstatements by the internal control
established by the client represents the control risk as the second tier. Furthermore, the
remaining risk of material misstatements passing through the client internal control
might be detected by conducting an independent audit to perform substantive tests and
collect audit evidence. Failure to detect any material misstatements after performing
the audit procedures is called the detection risk (the third tier). As discussed before, the
detection risk is something that the auditor can manage by decreasing/increasing the
substantive tests and audit evidence. The last tier is the audit risk that represents the
auditors willingness to acknowledge risk of material misstatements that might exist in
the clients financial statements even after the audit has been completed.


Materiality

All risks we have discussed are associated with the risk of material misstatements that
becomes the ultimate concern, as the risk of immaterial misstatements usually doesnt
bother the stakeholders too much. Accordingly, it is important to understand the
concept of materiality for the auditors to define material or immaterial issues when
conducting an audit.

ASA/ISA 320.2 defines materiality as information, individually or in aggregate that if
misstated or omitted from a financial report may adversely affect decisions about the
allocation of scarce resources by financial resource users.

Figure 2
Rule of Thumb for Planning Materiality

Auditors must determine the level of materiality for the financial report as a whole and
particular classes of transactions, account balances and disclosures. For example, if
auditors decide that the level of materiality for account balances is 5% of net profit

which is $10,000, then it means that any misstatements of account balances that reach
or surpass that amount is considered material and needs adjustments. The auditors
must also determine the level of materiality for particular classes of transactions or
disclosures. Furthermore, the auditors must consider qualitative factors as well as
quantitative assessment of materiality. For example, if particular classes of transactions
have immaterial misstatements in amount but indicated as a fraud, the auditors must
consider the misstatements are qualitatively material thus must be taken into account
for audit adjustments.

Figure 3
The Relationship between Materiality and Audit Risk










The level of materiality eventually will affect the audit risk the auditors are willing to
accept. The higher the level of materiality determined by the auditors, the lower the
audit risk becomes. The simple explanation about this relationship is because the
auditors uses samples in performing audit procedures and cant assure that the
financial statements are free from all kinds of misstatements. Instead, they only focus on
the material misstatements by which the level of materiality has been determined. For
example, if the auditors use 100 samples of transactions out of 1000 population of
transactions, and determine the level of materiality for transactions to be $1000, then
the auditors might only focus to do audit adjustments towards the samples of
transactions that have misstatement amount equal or above $1000 and disregard other
misstatements below that amount ($500, $300, $200, etc). In fact, the collection of
immaterial misstatements (below $1000) can become material in amount if they are
summed up all together or when considering the whole population instead of just audit
samples.


Audit Risk Model (ARM)

Having discussed the types of risk and the level of materiality, now we can derive the
ARM to help auditor to assess risks of material misstatements. Theoretically, the ARM is
given as follows:


AR = IR x CR x DR
AR = Audit Risk

IR = Inherent Risk

CR =Control Risk

DR = Detection Risk
Risk of Material Misstatements (RMM)

Research for Empirical Evidence

From the perspective of positive accounting theory, for a theory to be valid it needs to
be tested based on empirical evidence. Therefore, to prove that the Audit Risk Model
(ARM) holds in performing audit, we must collect empirical evidence by conducting
research or examining previous studies.

Ruhnke and Schmidt (2014) suggest that there is a relationship between inherent risk
and control risk factors and audit adjustments. This study relates to the ARM because
according to the ARM inherent risk and control risk will determine how many material
misstatements occur in financial statements and need to be detected by auditors
through audit procedures including substantive tests and collection of audit evidence. In
other words, inherent and control risk factors will determine the amount of audit
findings. The higher the inherent and control risk factors, the more the audit findings or
audit adjustments would be. This study is quite consistent with the previous studies
examining the relationship of inherent and control risk factors with the magnitude of
audit adjustments (Johnson 1987; Wallace and Kreutzfeldt 1991).

Research Question

The study by Ruhnke and Schnidt (2014) is primarily to answer a research question.

RQ: Do audit adjustments vary systematically with inherent risk and control risk
factors?

The words vary systematically indicates if there is an obvious pattern to understand
the correlation or the cause and effect relationship between inherent and control risk
factors and audit adjustments.

Research Data

Population (N) = 7,500 audit clients
Samples planned (n) = 405 audit clients
Samples observed (n) = 255 audit clients (63% of samples planned)
Audit adjustments from 255 samples = 1,148 adjustments (corrected and uncorrected
or waived adjustments)

Data collected from 255 audit clients comprises questionnaires and financial data of
adjustments from the samples. There are 1,148 audit adjustments from 255 samples
including corrected and uncorrected or waived adjustments).


Research Model

The study uses multivariate regression to examine the relationship between inherent
and control risk factors and audit adjustments. Audit adjustments would be the
dependent variable (Y) that is elaborated into five types/modes. Inherent and control
risk factors would become the independent variables that might influence the
dependent variable (Y) supported by other control variables. Moreover, inherent and

control risk factors together with the control variables are elaborated into several
proxies.

Dependent Variable (Y)

Audit Adjustments

Proxies

Independent Variables (X)

Inherent Risk Factors

Control Variables

of all
income
income
income

Proxies

Control Risk Factors

The number of adjustments (Y1)
The relative magnitude of the total
adjustments (Y2)
The relative magnitude of the total of
affecting adjustments (Y3)
The relative magnitude of the total of
increasing adjustments (Y4)
The relative magnitude of the total of
decreasing adjustments (Y5)

Competence and integrity of clients management
(QUALITY = X1)
Client economic position (ALTMANZ = X2, LOSS =
X3)
Remuneration system (REMUNERATION = X4)

Entity-level controls (ELC = X5)
Internal audit (INTAUDIT = X6)
Audit committee (AUDCOMM = X7)
Internal control system (ICS = X8)
Audit inputs/audit efforts/substantive tests
performed (AUDIT INPUT = X9)
Accounting standards used (GAAP = X10)
Industry Sector (INDUSTRY = X11)
Client TENURE (TENURE = X12)
Public or non public companies (LISTED = X13)

The regression model can be summarized as follows:

Y1 = + 1 QUALITY + 2 ALTMANZ + 3 LOSS + 4 REMUNERATION + 5 ELC + 6
INTAUDIT + 7 AUDCOMM + 8 ICS + 9 AUDIT INPUT + 10 GAAP + 11 INDUSTRY
+ 12 TENURE + 13 LISTED +

Y2 = + 1 QUALITY + 2 ALTMANZ + 3 LOSS + 4 REMUNERATION + 5 ELC + 6
INTAUDIT + 7 AUDCOMM + 8 ICS + 9 AUDIT INPUT + 10 GAAP + 11 INDUSTRY
+ 12 TENURE + 13 LISTED +

Y3 = + 1 QUALITY + 2 ALTMANZ + 3 LOSS + 4 REMUNERATION + 5 ELC + 6

INTAUDIT + 7 AUDCOMM + 8 ICS + 9 AUDIT INPUT + 10 GAAP + 11 INDUSTRY
+ 12 TENURE + 13 LISTED +

Y4 = + 1 QUALITY + 2 ALTMANZ + 3 LOSS + 4 REMUNERATION + 5 ELC + 6
INTAUDIT + 7 AUDCOMM + 8 ICS + 9 AUDIT INPUT + 10 GAAP + 11 INDUSTRY
+ 12 TENURE + 13 LISTED +

Y5 = + 1 QUALITY + 2 ALTMANZ + 3 LOSS + 4 REMUNERATION + 5 ELC + 6
INTAUDIT + 7 AUDCOMM + 8 ICS + 9 AUDIT INPUT + 10 GAAP + 11 INDUSTRY
+ 12 TENURE + 13 LISTED +

Note:
Y1 Y5 = Dependent variables (audit adjustments)
1 5 = Coefficients of Independent Variables
= Constanta

= Residual Error


Research Findings

a. Only some of inherent risk factors to have an impact on audit adjustments
(QUALITY and ALTMANZ scores). The higher the integrity and competence of the
management and the client economic position, the lower the magnitude of
adjustment. QUALITY is significant in Model 2, 3 and 5. ALTMANZ is significant in
Model 1, 3, and 5. Model 5 explains lower income-decreasing adjustment for clients
with stronger economic positions. No supports or significant effects for
REMUNERATION and LOSS.

b. Stronger associations of audit adjustments with ELC and INTAUDIT suggesting a
negative sign across all models. The stronger the ELC and INTAUDIT, the lower the
adjustments and the magnitude of adjustments. INAUDIT is significant in Model 2
and 4. The finding also suggests that the ELC may also serve a suitable proxy for
assessing the overall internal control system. AUDCOMM and ICS are only
significant in certain model (Model 1). ICS is significant in Model 1 when ELC is
insignificant in Model 1 suggesting that higher ICS might reduce the number of
audit adjustments but not the magnitude. ELC is usually associated with non
routine transactions which are substantial in amount, thus the higher the ELC might
reduce the magnitude of each of audit adjustments, but not the number.

c. Control Variables: AUDIT INPUT is positively associated with audit adjustments
(except in Model 4). Client Tenure (Model 3 & 5). The more substantive test
performed (AUDIT INPUT) and the longer the audit tenure conducted (more
auditors ability to understand the clients business and risks), the more audit
adjustments are found in number and magnitude.

Research Limitations

There may be other factors or variables associated with audit adjustments not
captured in this research
There are some misstatements undetected thus deteriorating the reliability of the
date used in this research
The study does not cover fraud risks that may exist in the samples.
Auditors rate certain factors themselves thus giving rise to potential measurement
errors (variables with four-level ordinal scale).

Inputs for Further Studies

To use time-series evidence
An analysis of adjustments at account or transaction-cycle levels
The effect of changes in audit environment (i.e. changes associated with materiality
consideration)
Other factors to be considered regarding to auditors ability to detect misstatements
(need audit adjustments): cultural factors, the composition of engagement team, the
audit teams experience with the clients sector.
The association of audit adjustments with inherent risks and control risks
according to ARM, indeed suggests that the auditor uses ARM in conducting the
audit. However, it doesnt show any empirical evidence whether auditor responds
to the assesses inherent risk and control risk factors by adjusting audit plans (need
further research and evidence).


Conclusion

The study by Ruhnke and Schmidt (2014) suggests that the inherent and control risk
factors are proven to affect the audit adjustments given specified control variables in
the regression models. Although some proxies of inherent and control risk factors fail to
prove that there is a strong relationship with the audit adjustment, the overall results of
the study still support the existence of the Audit Risk Model theory that we have learnt
during the lectures. Identification for better proxies and other technical improvements
are needed in further studies as described in the research limitations and inputs for
further studies.


Mapping of Learning Journal


Ground Theory:
Audit Risk Model (ARM)


-

Inherent Risk and Control

Risk Factors affect audit
adjustments

Critical Thinking:
For the theory to be valid, it must be
supported by empirical evidence or studies
(positive accounting theory)

Critical Questions:
Does ARM hold in reality as weve studied?

Critical Questions:
Can this relationship explain the facts
about ARM?

DO RESEARCH

-
-

RESEARCH FINDINGS

-
-

-
CONCLUSION

Critical Questions:
How to examine the facts?
What factors, variables, proxies,
samples and models to be used?
Results
and limitations?

Integrity & competence of the clients

management and clients economic
position (inherent risk proxies) affect
audit adjustments
Entity-level control and internal audit
(control risk proxies) affect audit
adjustments
Audit inputs and client tenure (control
variables) affect audit adjustments
Need more data and technical
improvements for further studies

There is a relationship between

inherent and control risk factors and
audit adjustments suggesting that the
ARM still holds to be true associated
with the theory we have learnt