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1
Q

All else held equal, would the following imply more work for the auditor or less work for the auditor?

  1. Higher control risk
  2. Higher inherent risk
  3. Higher detection risk
  4. Higher audit risk
A

AR = IR * CR * DR

  1. More work
    (increase in CR makes DR have to decrease)
  2. More work
    (increase in CR makes DR have to decrease)
  3. Less work
    (increase in DR allows AR to increase)
  4. Less work
    (increase in AR allows DR to increase)
2
Q

What would cause inherent risk to increase?

A

Volatility in oil price
Bank affected by FED rule changes
CEO engaging in questionable activities
(external factors)

3
Q

What is the only risk that auditors can control/change?

A

Detection Risk - means that the auditor can do more or less work

4
Q

“Filling the Assurance Bucket”

Order: efficiency perspective - where do you put your effort?

A
  1. Risk Assessment Procedures (“assessing” inherent risk, “understanding” control risk)
  2. Test of Controls (“assessing” control risk)
  3. Substantive Analytical Procedures (easier than test of details)
  4. Remaining assurance needed form test of details (“heavy lifting”)
5
Q

What assertions do auditors focus on for significant accounts?

A

Relevant assertions

6
Q

An account or disclosure is a significant account if…

A
  • There is a reasonable possibility that the account or disclosure could contain a misstatement
  • Individual or aggregated misstatement
  • Considering under and overstatements
7
Q

How is an account or disclosure determined as significant?

A

Based on inherent risk, without regard to the effect of controls

8
Q

A relevant assertion is…

A
  • A financial statement assertion with the reasonable possibility of containing a misstatement(s) that would cause the financial statements to be materially mistated
9
Q

How is a relevant assertion determined?

A

Based on inherent risk, without regard to the effect of controls

10
Q

Audit Risk

A

Probability that an auditor will give an unqualified opinion (clean) on materially misstated financial statements

11
Q

At what level is audit risk applied? Why?

A

Assertion Level
Directly assists the auditor in planning the appropriate audit procedures for the accounts, transactions, or disclosures (applied holistically)

12
Q

Audit Risk=

A

Inherent Risk * Control Risk * Detection Risk

13
Q

True or False: Audit risk is the risk that the auditor gives an incorrect audit opinion

A

False!
Not concerned with giving an unclean opinion to a clean financial statement

14
Q

Why is audit risk not concerned with giving an unclean opinion to a clean financial statement?

A

If I get a 100 on a test I don’t go back and look and make sure the professor graded it correctly (management incentives) BUT, if I get a 43, I’m going to go back and look and make sure my test is graded correctly

15
Q

Auditors have an incentive to…

A

push audit risk as low as possible

16
Q

Revenue - would completeness or existence/occurrence have higher inherent risk?

A

Existence/occurrence because management has an incentive to inflate revenue rather than push it down (risk of overstatement)

17
Q

COGS - would completeness or existence/occurrence have higher inherent risk?

A

Completeness (risk of understatement)

18
Q

Inherent Risk

A

Probability that, in the absence of internal controls, material misstatements could occur

19
Q

Factors that affect inherent risk:

A
  • The nature of the client’s business and strategy to achieve a competitive advantage
  • The major types of transactions
  • The effectiveness and integrity of managers and accountants
20
Q

Where is inherent risk more likely? Complex estimate or cash?

A

Complex estimate (requires more judgement)

21
Q

Control Risk

A

Probability that the client’s internal control policies and procedures fail to prevent or detect a material misstatement

22
Q

Factors that affect control risk:

A
  • The environment in which the company operates (its “control environment”)
  • The existence (or lack thereof) and effectiveness of control activities
  • Monitoring activities (audit committee, internal audit function, etc.)
23
Q

Detection Risk

A

Probability that the auditor’s substantive procedures will fail to detect a material misstatement that exists within an account balance or class of transaction

24
Q

Factors that affect detection risk:

A
  • Nature, timing, and extent of audit procedures
  • Sampling risk (the risk of choosing an unrepresentative sample)
  • Nonsampling risk (the risk that auditor may reach inappropriate conclusions based upon available evidence)
25
Q

What is the only part of the audit risk model that the auditor can control?

A

Detection Risk

26
Q

How can detection risk be described?

A
  • The “plug” figure
  • Inherent and control risk are assessed, now, how much detection risk do we as auditors need?
  • How much work do auditors have to do?
27
Q

RMM (Risk of Material Misstatement)

A

The risk that a material misstatement exists in the financial statements before auditors apply their substantive procedures

28
Q

RMM=

A

Inherent Risk * Control Risk

29
Q

The assessment of RMM leads to…

A

determination of Detection Risk
DR = AR/(IR*CR)

30
Q

The nature, timing, extent of Lower Detection Risk

A

Nature: More effective tests
Timing: More testing at year-end
Extent: More tests (volume)

31
Q

The nature, timing, extent of Higher Detection Risk

A

Nature: Less effective tests (more inquiry, less inspection)
Timing: More testing at interim
Extent: Fewer tests (volume)

32
Q

What is the probability that the audit work will NOT catch a material misstatement?

A

Detection Risk

33
Q

If you want the probability of missing test questions on a test you have to study…

A

MORE
(you have to work more for a lower detection risk)

34
Q

If auditors can’t push audit risk to an “acceptably low” risk, they are supposed to…

A

(by the standard) to refuse the client

35
Q

AR = IR * CR * DR
Low = Moderate * Moderate * ________

A

Moderate

36
Q

AR = IR * CR * DR
Low = Low * Low * ________

A

High

37
Q

What are the limitations of the Audit Risk Model?

A
  • Subject to the judgements and assessments used as inputs
  • It does not consider potential auditor error
  • Virtually impossible to calculate the exact level of IR,CR,DR, and AR (the model is conceptual)
  • RMM cannot =0
38
Q

Can RMM be assessed at 0?

A

No
Auditor wouldn’t have to do any work, it is not allowed

39
Q

What is the difference between fraud and error?

A

Intent

40
Q

Auditors obtain reasonable assurance that the financial statements are free from material misstatement, whether…

A

caused by fraud or error

41
Q

Fraudulent Financial Reporting

A

Intentional misstatements or omissions of amounts or disclosures intended to deceive financial statement users “management fraud”

42
Q

Misappropriation of Assets

A

Asset theft from the entity (usually, not always, lower level workers)

43
Q

Can fraudulent financial reporting lead to misappropriation of assets?

A

Yes, sometimes one can lead to the other

44
Q

Fraud Triangle

A
  1. Incentive or pressure to perpetrate fraud
  2. Opportunity to carry out the fraud
  3. Attitude or rationalization to justify the fraud
    (all 3 have to be present for fraud)
45
Q

Incentive for Fraud

A
  • Pressure from 3rd parties (ex: analysts)
  • Personal financial situation
46
Q

Opportunity for Fraud

A
  • Weak internal controls
  • Complex organizational structure
47
Q

Justification of Fraud

A
  • Nonfinancial management’s excessive participation in selection of accounting principles and estimates
  • History of violations of securities laws
48
Q

Communication of Fraud

A
  • Exercise significant care (accusations of fraud are taken very seriously by audit clients)
  • Evidence of fraud should be presented to the “appropriate level of management” (one level above the people involved)
  • Fraud committed by management is material and should be reported to those charged with governance (Audit Committee or Board of Directors)
49
Q

Direct-Effect Noncompliance

A
  • Produce direct and material effects on the financial statements
  • The law or regulation can be identified with a specific account or disclosure
  • Auditor’s responsibility: design procedures to provide reasonable assurance
50
Q

Indirect-Effect Noncompliance

A
  • Not related to specific accounts or disclosures on the financial statements (violations related to insider securities trading, occupational health and safety, food and drug administration, etc.)
  • Auditor’s responsibility: follow up on suspected violations material to the financial statements
51
Q

Do you have to “assess” or “understand” internal controls?

A

You have to develop an “understanding”

52
Q

What is the difference between “assessing” and “understanding”?

A

“assess”: test/validate
“understand”: no test (inquire, etc.)

53
Q

Obtaining an understanding of the client’s business includes understanding:

A
  • Industry, regulatory, and other external factors
  • Nature of the company and related parties
  • Effect of client’s computerized processing
  • Accounting principles and related disclosures
  • Company objectives, strategies, and related business risks
  • Company performance measures and analysis
54
Q

Preliminary Analytical Procedures

A
  1. Identify the potential problem areas
  2. Provide a standard starting place to start examining the financial statements
  3. Help familiarize audio with client’s business and identifying areas of risk
55
Q

When are analytical procedures required?

A

Preliminary stages (when creating the audit plan)
End (when performing the final plan)

56
Q

When are analytical procedures optional?

A

Substantive testing

57
Q

Analytical Procedure Steps

A
  1. Develop an expectation (that was developed before)
  2. Define a significant difference (aka “tolerable difference”)
  3. Calculate predictions and compare them with the recorded amount
  4. Investigate significant differences
  5. Document each of the above steps
58
Q

Audit team discussions (brainstorming)

A
  • Required procedure
  • Objectives
  • Discussions should be ongoing throughout the engagement
59
Q

What are the audit teams objectives in brainstorming?

A

Gain understanding of
- Previous experiences with client
- How a fraud might be perpetrated and concealed in the entity
- Procedures that might detect fraud
Set proper tone for engagement

60
Q

Inquiries of Company Leadership

A

Auditors discuss
- selection of accounting principles
- susceptibility to errors and fraud
- how management controls and monitors fraud risks

Talk to….
Audit Committee
Management
Internal Auditors

61
Q

Who is responsible for financial statements?

A

Management
(they should know where the risks are)

62
Q

Purpose of inherent risk assessment

A

Determine significant accounts and relevant assertions and how each can be misstated