Audit EXAM 4

Question 1

Test of controls

Answer 1

Tests of controls are audit procedures performed to evaluate the effectiveness of an entity’s internal controls in preventing or detecting material misstatements in financial reporting. These tests help auditors determine whether they can rely on the client’s internal controls or if they need to perform more substantive testing.

Question 2

Objectives of Tests of Controls

Answer 2

• Ensure that internal controls are properly designed and function as intended.
• Assess whether employees consistently follow established policies and procedures.
• Reduce the need for extensive substantive testing if controls are effective.
• Identify weaknesses in internal controls that could lead to fraud or misstatements.

Question 3

5 types of test of controls:

Answer 3

1. Inquiry – Asking management and employees about how controls operate.
2. Observation – Watching employees perform control activities in real time.
3. Inspection of Documents – Examining records, reports, and authorizations to verify compliance with controls.
4. Reperformance – The auditor re-executes the control process to check if it works correctly.
5. Walkthrough Testing – Following a transaction from initiation to completion, reviewing control steps along the way.

Question 4

3 types of audit risks:

Answer 4

1. Inherent Risk:
   The risk of material misstatement before considering internal controls. It arises due to the nature of the business, transactions, or external factors.
2. Control Risk:
   The risk that a company’s internal controls fail to prevent or detect a material misstatement in financial statements. This means errors or fraud could occur despite having internal controls in place.
3. Detection Risk
   The risk that auditors fail to detect a material misstatement in financial statements, either due to ineffective audit procedures or human error.

Question 5

Audit Risk Formula:

Answer 5

AuditRisk=InherentRisk×ControlRisk×DetectionRisk

If inherent and control risks are high, auditors must reduce detection risk by performing more substantive testing.

If controls are strong, detection risk can be lower, requiring fewer audit procedures.