Misstatement Risk

This class includes a case study and a lab component. The case study explores the concept of audit risk, specifically the risk of material misstatements in financial statements, and the critical role that internal controls play in managing this risk. It emphasizes the distinction between unintentional errors and fraud, the latter being an intentional act leading to misstatements. The study introduces the F-score, a predictive metric developed by Professor Weili Ge and colleagues, which estimates the likelihood of a company’s accounting estimates being misstated based on a range of financial and non-financial indicators. By utilizing data analytics, the F-score provides a systematic way to assess misstatement risk through factors such as changes in receivables, inventory, accruals, and market-based information. Additionally, the case includes a practical lab exercise where students can replicate part of the analysis using the F-score model, allowing for hands-on experience in assessing misstatement risk with real-world data.

Why is this important?

Understanding the risk of material misstatements is essential for graduate accounting students as it equips them with the ability to evaluate the accuracy and reliability of financial statements, a critical aspect of the auditing profession. By mastering tools like the F-score, students can develop skills in identifying potential accounting manipulations, which are increasingly important as companies face complex financial reporting environments. This knowledge prepares students to assess the effectiveness of internal controls, ensuring that they can detect weaknesses that may lead to financial misstatements or fraud. Furthermore, the practical application of data analytics in this context enables students to bridge the gap between theoretical knowledge and real-world auditing practices, making them more effective professionals.

Materials:

Case: Risk of Misstatement and Internal Controls.
Slides: will be available for download by the beginning of class in either powerpoint or pdf formats.
Data: A data update may be required for this class. To ensure your files are the most up-to-date, navigate to ACCTG521_Labs folder and run the command git pull.
Analytics Tools: Alteryx two-sample t-test tool
Analytics Tools: Git and GitHub

Review and Extension:

Building on the prior class's focus on audit planning and risk assessment, this class delves deeper into how auditors address the risks of material misstatements by assessing the effectiveness of internal controls. While the previous class introduced key audit risks such as inherent and control risk, this session focuses on quantifying these risks using tools like the F-score, which helps auditors evaluate the likelihood of misstatements based on specific financial and non-financial indicators. By linking audit planning with the identification and measurement of misstatement risk, students gain a comprehensive understanding of how audit strategies are designed and adjusted in response to the client's control environment and financial data.

Preparation:

1. Before class, please read through the Case: Risk of Misstatement and Internal Controls
2. Optional Detailed Background Reading: If you want to read more about the firm characteristics that predict misstatement and why the authors predict a certain relation, Predicting Material Accounting Misstatements is the academic paper that the case analysis is based upon. I recommend only reading Section 1. Introduction (p.1-6) and Variables Analyzed Section (includes Accrual Quality, Performance, Nonfinancial measures, Off-balance-sheet activities, and Market-related incentives subheaders - bottom of p.18 - middle of p.26).
3. Prep Question 1: What are firm characteristics that potentially predict a higher or lower probability of material misstatements? Be ready with at least two characteristics, whether they predict higher or lower misstatement risk, and why. (HINT: Many are discussed in the case, and you are welcome to come up with different ideas if you want.)
4. Prep Question 2: What are firm characteristics that potentially predict a higher or lower probability of internal control weaknesses? Be ready with two characteristics, whether they would predict higher or lower probability of internal control weaknesses, and why.

Class Plan:

Teams: during this class, please sit in your discussion teams.

1. Preparation questions will be discussed in preparation teams with warm call used to facilitate the full class discussion.
2. The labs will require a git pull to the ACCTG521_Labs folder. Make sure you open the cmd in the correct folder, not any of the subfolders.
3. The plan is to use either Alteryx with Tableau, or just Alteryx in this lab to visualize misstatement risk.