And again, go out to your favorite financial
oriented websites, whether that's Wall Street Journal, SmartMoney.com,
Squat Pox, MSNBC,
Fox Business, and Yahoo Finance is another good one, and become...and we will do this
later in the course for one particular company and
one industry just to get you deeply ingrained in
this, but you have to develop informed expectations, not naive expectations.
And then, as you develop those informed expectations,
not only of what income is likely to be, but also
how income should be correlated to accounts
receivable or cash receipts, or if
the income is going to be fueled by new investment in property,
in plant and equipment, new factories.
How there should be an uptick in factories, or if it's gonna be
financed or moved by new hires of talent,
that their labor costs should go up.
You, as an auditor,
you really almost want to create some pro-forma financial statements and
pro-forma footnote disclosures to those financial statements ahead of time.
What you think management should be.
Not that you're wed to those,
but that's just going to give you a benchmark against which to compare what you observe.
It will also tell you how carefully you will observe in different areas.
Places where you expect certain level of performance, and so
does everyone else and it's very unlikely that this will not be realized,
you probably do not have to observe things as carefully there as you would in areas
where your expected level of performance
is there, but it's not there with a lot of confidence.
So, one version of risk assessment is as follows.
You go in and you invest in your understanding of the client deeply,
you listen to analysts reports,
you read analysts reports,
you become an industry and company expert.
And of course, if you audit a company for multiple years,
you will become an expert in that company.
And then you go out and observe and what you find is
a huge amount of overlap between what you expect,
and expect here is abbreviated by E and what you observe.
And if there's a high degree of overlap between what you expect and you observe,
what do you think you do with respect to how
likely it is that there is a material misstatement?
Well you ordinarily would say there's a low risk of material misstatement.
That's not the same thing as zero risk, but it does tell
you in my portfolio of audit clients,
here's a company where I'm not going to have to put an inordinate amount of
effort in before I can come to
reasonable assurance that the financial statements are free of misstatement.
On the other hand,
if you're that same auditor who took an opportunity
to become an expert in that industry and that client,
and you see a lot of discordance between what you expected and what you observe,
one of two things is now happening.
One, is that there is a material misstatement in the financial statements.
Something's wrong precisely because what you observe is very different than what you
expected and what you expected was based on sound knowledge and understanding.
Or, what's the other possibility?
Well, that you don't know as much about the business as you thought.
So you may have to go back and say,
my entire mental model for how this company was going to create value for this period,
needs to be reworked.
So stepping back. Risk assessment is
primarily driven by the degree of concordance or discordance,
discord or overlap, between what you expect and observe as an auditor.
What I mean and expect and observe,
I mean your expectations are not frivolously formed,
they are deeply and thoughtfully formed and
your observations similarly are not half-hearted,
frivolous observations involving mere inquiry of management.
They are careful, deliberate, well thought out observations.
Mark E. Peecher, PhD, CPAAssociate Dean of Faculty and Deloitte Professor of Accountancy
