Ch. 4 - Risk Assessment

Question 1

What are the major phases of an audit?

Answer 1

1. Client acceptance/continuance ->
2. Preliminary engagement activities ->
3. Plan the audit ->
4. Consider the audit ->
5. Audit business processes and related accounts ->
6. Complete the audit ->
7. Evaluate results and issue audit report

Question 2

The audit risk model serves as a….

Answer 2

framework for assessing audit risk

Question 3

Why do auditors follow a risk assessment process?

Answer 3

To identify the risk of material misstatement in the financial statement accounts.

Question 4

What components make up the risk of material misstatement?

Answer 4

Inherent risk and control risk

Question 5

The risk of material misstatement is used to determined the…..

Answer 5

acceptable level of detection risk and to plan the auditing procedures being performed.

Question 6

Misstatement

Answer 6

A difference between the amount, classification, presentation, or disclosure of a reported financial statement item and the amount, classification, presentation, or disclosure that is required for the item to be presented fairly in accordance with the applicable financial reporting framework.

Question 7

Audit risk

Answer 7

The risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated.

Aka, audit risk is the risk that an auditor will issued an unqualified opinion on materially misstated financial statements.

Question 8

Audit risk must be considered at what level?

Answer 8

At the classes of transactions, account balances, and disclosures levels.

Question 9

At the assertion level, audit risk consists of…

Answer 9

1. The risk that the relevant assertions related to the class of transaction, account balance, or disclosure contain misstatements that could be material to the financial statements (risk of material misstatements).
2. The risk that the auditor will not detect such misstatements (detection risk)

In other words, audit irks is the combination of these components–that the entity’s financial statements contain material misstatements and that the auditor fails to detect any such misstatements.

Question 10

Audit procedures

Answer 10

Specific acts performed as the auditor gathers evidence to determine if specific audit objectives are being met.

Question 11

Inherent risk

Answer 11

The susceptibility of an assertion in an account or disclosure to a misstatement due to error or fraud that could be material, either individually or when aggregated with other misstatements, before consideration of any related controls.

Question 12

Control risk

Answer 12

The risk that a misstatement that could occur in an assertion about an account or disclosure and that could be material, either individually or when aggregated with other misstatements, will not be prevented, or detected and corrected, on a timely basis by the entity’s internal control.

Question 13

True or false: the auditor is resposible for detecting misstatements in inherent risk and control risk

Answer 13

False–they are not.

Question 14

Risk of material misstatement (RMM)

Answer 14

The risk that the financial statements are materially misstated prior to the audit. Also known as “client risk.”

Made up of inherent risk and control risk

Question 15

Detection risk (DR)

Answer 15

The risk that the procedures performed by the auditor will not detect a misstatement that exists and that could be material, either individually or when aggregated with other misstatements.

Question 16

Nonsampling risk

Answer 16

The risk that auditors will make judgment errors caused by the use of inappropriate audit procedures or misinterpretation of audit evidence and failure to recognize a misstatement or deviation.

Question 17

What is the audit risk model formula?

Answer 17

AR = RMM x DR
(where RMM = IR x CR)

Question 18

Engagement risk

Answer 18

The risk that the auditor is exposed to financial loss or damage to his or her professional reputation from litigation, adverse publicity, or other events arising in connection with financial statements audited and reported on.

Question 19

What are the steps involved in the auditor’s use of the audit risk model at the assertion level?

Answer 19

1. Set a planned level of audit risk
2. Assess the risk of material misstatement.
3. Determine the appropriate level of detection risk.

Question 20

For publicly traded companies, auditors typically set planned audit risk at _____

Answer 20

5% or less.

Question 21

What formula is used to determine the appropriate level of detection risk (by solving the audit risk model)?

Answer 21

AR = RMM x DR
DR = AR/RMM

Question 22

What is the relationship to the entity’s business risks to the audit risk model?

Answer 22

1. Assess the entity’s business risks ->
2. Relate those risks to what can go wrong at the account balance or disclosure level
3. Assess the risk of material misstatement (aka the inherent and control risks) ->
4. This means that the audit risk is then then RMM x detection risk

Question 23

Risk assessment

Answer 23

The identification, analysis, and management of risks relevant to the preparation of financial statements that are fairly presented in conformity with GAAP.

Question 24

Business risk

Answer 24

A risk resulting from significant conditions, events, circumstances, and actions or inactions that could adversely affect an entity’s ability to achieve its objectives and execute its strategies or from the setting of inappropriate objectives and strategies.

Question 25

Audit data analytics (ADA)

Answer 25

Using analysis, modeling, and visualization to discover and analyze patterns, anomalies, and other information in data in the context of the audit.

Question 26

Analytical procedures

Answer 26

Evaluations of financial information made through analysis of plausible relationships among both financial and nonfinancial data.

Question 27

The risk of material misstatement refers to misstatements caused by ________ or _________

Answer 27

errors or fraud

Question 28

What is an overview of the auditors risk assessment process?

Answer 28

Step 1: Perform risk assessment procedures:
–Inquires of management and others
–Analytical procedures, including audit data analytics, and
–Observation or inspection to obtain an understanding of the entity and its
environment.

(What observation and inspection can tell you:
–Nature of the entity
–Selection and application of accounting principles
–Industry, regulatory, and external factors
–Entity objectives, strategies, and business risks
–Entity performance measures
–System of internal controls)

Step 2: Identify business risks that may result in material misstatements in the financial statements

Step 3: Evaluate the entity’s risk assessment process (i.e, how management responds) to those business risks and obtain evidence of its implementation

Step 4: Assess the risk of material misstatement at the financial statement and assertion levels.

Question 29

Factual misstatements

Answer 29

These are misstatements about which there is no doubt. For example, an auditor may test a sales invoice and determine that the prices applied to the products ordered are incorrect. Once the products are correctly priced, the amount of misstatement is known. In such cases, the auditor knows the exact amount of the misstatement.

Question 30

Judgmental misstatements

Answer 30

These are misstatements that arise from the judgments of management concerning accounting estimates that the auditor considers unreasonable or the selection or application of accounting policies that the auditor considers inappropriate.

Question 31

Projected misstatements

Answer 31

These are the auditor’s best estimate of misstatements in populations, involving the projection of misstatements identified in an audit sample to the entire population from which the sample was drawn.

Question 32

What are the two types that fraud can be classified into?

Answer 32

1. Misstatements resulting from fraudulent financial reporting and
2. Misstatements resulting from misappropriation of assets. This includes:
   –Embezzling cash received
   –Stealing physical assets and intellectual property
   –Causing the entity to pau for goods or services not received
   –Using the entity’s assets for personal use

Question 33

What three confitions are generally present when material misstatements due to fraud occur?

Answer 33

1. Management or other employees have an incentive or are under pressure that provides a reason to commit fraud
2. Circumstances exist that provide an opportunity for fraud to be perpetrated.
3. Those involved are able to rationalize committing a fraudulent act. Some individuals possess an attitude, character, or set of ethical values that allow them to knowingly and intentionally commit a dishonest act.

These three conditions are sometimes known as the fraud risk triangle.