So, in this lesson,
we're going to build on the basic building blocks of assertions and start talking
about a set of steps for assessing RMM,
what might that stand for, in verifying assertions.
RMM is the risk of material misstatement.
Risk of material misstatement is the product of inherent risk and control risk.
Now, we'll cover that again,
we covered all three inherent, control, and detection risk a few lessons ago.
But you should now be getting comfortable with the risk of
material misstatement being that part of the risk that the auditor mostly assesses.
And then, when the auditor reacts to the risk of material misstatement by
constructing verification procedures that is actually driving down detection risk.
The goal, remember, is to have the risk of
material misstatement times detection risk, equal a sufficiently low number,
and that number is called audit risk.
You want the overall audit risk to be acceptably
low and that's going to be driven in part by risk of material misstatement,
and in part by detection risk,
in part by inherent and control risk,
and in part by detection risk.
So the first thing to do when you're trying to assess the risk of material misstatement,
you have to actually identify the assertions being made by the asserter.
And you will quickly come to understand that various accounts in
a financial statement, have their usual suspects of higher versus lower inherent risks.
Now, whether that's a higher or lower risk of material misstatement,
really depends on what kind of firm you have.
If it's a control conscious firm, with a strong tone at the top,
they're going to invest in internal controls over financial reporting.
Where are they going to do that?
Well they'll do that precisely where the inherent risks are higher.
So just because you have higher inherent risk,
doesn't mean you have higher risk of material misstatement.
So when you're thinking about inventory,
are you usually going to be worried about the completeness of
inventory, or the existence of inventory?
Well, like most assets,
you're going to be more worried about the existence of inventory, because
that speaks to an overstatement potential for inventory.
An overstatement of inventory will do what in
terms of total assets? Overstate total assets.
It will do what, in terms of net income? It will overstate net income. You see.
So most companies tend to want to exaggerate the performance,
rather than to under-report their performance.
In fact, the only time they want to
under report their performance is maybe if they think there's going to be
like a labor strike, or they want to take a poison pill to look
less attractive because they're being, potentially a takeover target.
So you identify these assertions being made,
and you know that different account balance have
the usual suspects of higher risk assertions.
The next step is that you assess and justify the risk of material misstatement.
Well how do you assess and justify this risk?
It will differ by firms.
Firms don't assess a particular probability here.
When I talk to my friends in the decision sciences or even meteorologists,
they'll say the chance of rain or chance of thunderstorm is 30% tomorrow.
We don't see this in auditing.
They don't really say the inherent risk of
the valuation assertion and inventory is 80%,
it just doesn't happen.
Audit textbooks sometimes use these numbers but that's just to be very
infantile and helping you through the first few early problems.
What the firms do instead is that they classify inherent risk
into 2 to 5 buckets, usually 2 or 3.
So, when I say that, it's either going to be lower or higher,
or low, medium, high,
that's what you usually see.
The inherent risk assessments are done by
professional judgment by a professional, who has a deep understanding of that client.
So, if you're following Starbucks... I mean if you're an auditor
of Starbucks and I think that's Deloitte these days, and has been for some time,
you're going to be wanting to follow the coffee industry very very carefully,
and you're going to be listening to
the earnings calls of Starbucks regularly every quarter.
You're going to become deeply familiar with that company and you will
understand where in the financial statements at
Starbucks there are greater and lower risks of material misstatement.
A company like Starbucks with, what seems to me, to be
a pretty strong tone at the top, in terms of financial reporting.
You're probably not going to have terribly many super high inherent risks,
but you may have some high and a few medium.
You're going to do this by, again,
looking at the things like integrity of management,
the complexity of the estimation process used to derive the account balance.
Sometimes these estimates are straightforward,
like if you're doing straight-line depreciation, that's sort of pretty much plug and chug.
If you're doing a fair value estimate,
and you're looking at a situation where, if you
know you're a gap there when it comes to fair value of some instruments,
you have level 1,
level 2, level 3.
Once you get away from a situation when you're assessing fair value easily,
because it's a level 1 situation where you can just look
into the Wall Street Journal for stock price,
there's a market price readily stated.
Sometimes you have to develop a model to estimate the fair value.
Well, if you're developing a model to estimate the fair value management is,
it becomes a lot more subjective,
a lot more susceptible to being wrong, inherently.
How much risk of material misstatement is there?
Well, you can't stop with inherent risk,
you have to also look at control risk.
