Hi, audit learners. Hey, this time we're going to take a deeper dive into risk assessment. Risk assessment is arguably the central driving facet of an audit. It is how you govern the collection of evidence, the assignment of personnel to the audit engagement. If an auditor cannot accurately assess risks of particularly material misstatement, you're not going to know how to allocate your audit resources, and then you're left in a world where you can only randomly test assertions, as opposed to use risk-based auditing. So we need to understand what a quality risk assessment looks like. When you think of risk assessments in auditing, please recognize that the financial statements are supposed to be a faithful representation of select business states of the audited entity. So, you have to understand the business, you cannot just come to learn about the business only from the bottom up, what I would say, starting with the financial statements, pouring over those, and saying, wow, they have revenue in from different segments in different parts of the United States, so they must have a business that spans the country. No, you don't want to use the financial statements to find that out, you want to get out above those financial statements and understand the entity. Understand if it's a physical company, where its outlets are. You may want to visit a number of these outlets, whether it's Fargo, or AIMS, or Sacramento, wherever. You need to understand that the risk assessment process is not just assessing risk of material misstatement, but also getting a sense for the business risks that clients face. When I say business risks, what is a business risk? Well a business risk is that a client's business objective will not be obtained. Okay. So you can't have a risk without first obtaining a sense of what is the objective. So maybe, the objective is to have 4 new patents within a biopharmaceutical, or maybe the risk... maybe the objective is to increase your market share by 5%. Then you have to say, well what's the risk that that doesn't happen and if that doesn't happen, why would you care as an auditor? Well, you would care as an auditor, because when business risks are not controlled very well by management, or when management's key business process objectives are not attained, what do you think that does to their incentive to stretch the truth when it comes to their financial reporting? Yeah, you're right, it makes them they have a greater incentive to stretch the truth. So, you have to get out ahead of this as the auditor. So you want to look at the extent to which your clients planned responses to business risks is a sound plan, and are they reacting to pressures within their environment or not. Especially if it's a technologically, rapidly, changing environment. Okay. So, they may not be paying attention, and they may think they have the world's greatest interface with computers or gaming console, right? They've sold a lot of those in the past. Unless they're monitoring what other people are doing, the products that sold very well in the past are becoming obsolete right before their eyes. You can't just look at past financial performance as a financial statement auditor, right? You can't look at past sales of inventory to assess the obsolescence of items held in inventory today. Okay? So, a high quality auditor is going to fundamentally, and you can look at PCOB standards, or AICPA standards, you're going to fundamentally take a deep dive into that audited business. You should listen to equity analyst and read equity analysts reports. You should, if you're going to be auditing companies within various agricultural, or real estate, or entertainment industries, become an expert on that industry. Subscribe to periodicals that cover that industry and give you KPIs about that industry. So you want understand what are the drivers of profitability in the client that you're looking at. Is it capital intensive? Is it labor intensive? If it's labor intensive, where are they gonna get their human capital? What liquidity pressures are they going to have? Are they going to be able to get more financing, as needed, to finance needed expansion, to deliver new products? And the marketability of their products. You also have to be concerned with employee morale and in retention. This gets at the cost of labor. It can also get at the cost of this managing human capital. It also can get at the prospect of a strike. So you have these rapidly changing business risks. These business risks, if not properly managed, are going to be harbingers, forerunners of heightened risk, of material misstatement. So why does the auditor need to understand the company's business from the top down, from the company management business processes down, instead of just through the financial statements bottom up? It's because that's going to help you in a proactive way understand where new misstatement risks are going to be popping up. Potentially, like literally popcorn, you need to be mapping this.
