Chapter 4 Flashcards
(16 cards)
Q: 🔹 What is the audit risk model, and how does it guide audit planning?
A:
🔸 The audit risk model helps the auditor manage the risk of providing an inappropriate opinion on financial statements that are materially misstated
🔸 The model helps auditors decide how much audit work is needed and how rigorous it should be and where to focus testing
🔸 It involves four key components:
🔹 Acceptable audit risk – the maximum overall risk the auditor is willing to accept that a material misstatement remains undetected after the audit
🔹 Inherent risk – the likelihood that a material misstatement could occur before considering any internal controls
🔹 Control risk – the likelihood that the client’s internal controls will fail to prevent or detect that misstatement
🔹 Planned detection risk – the risk that the auditor’s own procedures will fail to detect a misstatement
🔸 Auditors assess inherent and control risk based on their understanding of the client
🔸 They set an acceptable level of audit risk
🔸 Then they design audit procedures to lower planned detection risk as needed to keep the total risk within acceptable limits
Q: 🔹 What is acceptable audit risk, and how does it affect the audit?
A:
🔸 Acceptable audit risk is the maximum overall risk the auditor is willing to accept that the financial statements are materially misstated, but the audit does not detect it
🔸 It reflects the auditor’s comfort level with issuing a clean opinion
🔸 Lower acceptable audit risk is chosen when:
🔹 Financial statements are used by many or important stakeholders
🔹 The client is publicly traded or highly regulated
🔹 There is greater risk of litigation
🔹 Management integrity is questionable
🔸 Lower AAR means more audit work, because the auditor needs greater assurance that material misstatements will be detected
Q: 🔹 What is inherent risk, and how does it affect audit planning?
A:
🔸 Inherent risk is the likelihood that a material misstatement exists in an account or transaction before considering any internal controls
🔸 It depends on the nature of the item being audited, not on the client’s controls
🔸 Inherent risk is higher when:
🔹 Transactions are complex, subjective, or non-routine
🔹 There is high volume or manual processing
🔹 The industry is volatile or heavily regulated
🔹 There is susceptibility to fraud (e.g., cash, estimates)
🔸 Higher inherent risk → more audit procedures required to obtain sufficient evidence
Q: 🔹 What is control risk, and how does it affect audit work?
A:
🔸 Control risk is the likelihood that a material misstatement will not be prevented or detected by the client’s internal controls
🔸 Control risk is affected by the design and effectiveness of the client’s control systems
🔸 Control risk is higher when:
🔹 Controls are missing, poorly designed, or not followed
🔹 The client is small or lacks segregation of duties
🔹 The auditor cannot test the controls effectively
🔹 There is a history of control failures
🔸 High control risk → less reliance on controls → more emphasis on substantive testing
Q: 🔹 What is planned detection risk, and how does the auditor manage it?
A:
🔸 Planned detection risk is the risk that the auditor’s procedures will fail to detect a material misstatement in the financial statements
🔸 It is the only component the auditor directly controls
🔸 It reflects the amount and quality of audit work the auditor needs to perform, based on their assessment of:
🔹 Acceptable audit risk
🔹 Inherent risk
🔹 Control risk
🔸 When those other risks are high, planned detection risk must be low, requiring more extensive or rigorous audit procedures
Q: 🔹 What factors affect acceptable audit risk (AAR), and how?
A:
🔹 High number of FS users / public company ↓ AAR
🔹 Client in poor financial health ↓ AAR
🔹 High risk of litigation ↓ AAR
🔹 Management integrity concerns ↓ AAR
🔹 History of errors or restatements ↓ AAR
🔹 Aggressive accounting policies ↓ AAR
🔹 Volatile industry or high business risk ↓ AAR
🔹 Private company / limited users ↑ AAR
🔹 Stable industry and business operations ↑ AAR
🔹 Strong management reputation ↑ AAR
Q: 🔹 What factors affect inherent risk (IR), and how?
A:
🔹 Complex transactions or estimates ↑ IR
🔹 High volume of transactions ↑ IR
🔹 Manual systems / lack of automation ↑ IR
🔹 Subjective accounting areas (e.g., fair value) ↑ IR
🔹 New accounting standards or reporting frameworks ↑ IR
🔹 Significant changes in operations or personnel ↑ IR
🔹 Poor past experience with specific account areas ↑ IR
🔹 Volatile industry or external sensitivity ↑ IR
🔹 Assets susceptible to theft or fraud (e.g., cash) ↑ IR
🔹 Related party transactions ↑ IR
🔹 Non-routine or unusual transactions ↑ IR
🔹 Complex financial instruments ↑ IR
Q: 🔹 What factors affect control risk (CR), and how?
A:
🔹 Weak or poorly designed internal controls ↑ CR
🔹 Lack of segregation of duties ↑ CR
🔹 Controls not operating effectively ↑ CR
🔹 Inadequate documentation of processes ↑ CR
🔹 Lack of internal audit function ↑ CR
🔹 High turnover in accounting personnel ↑ CR
🔹 Prior year control deficiencies ↑ CR
🔹 Auditor unable to test controls ↑ CR
🔹 Small company environment (less formality) ↑ CR
🔹 Strong control environment ↓ CR
🔹 Effective design and implementation of controls ↓ CR
🔹 Reliable documentation and monitoring ↓ CR
🔹 Strong internal audit function ↓ CR
🔹 Prior year controls tested and effective ↓ CR
Q: 🔹 What factors affect planned detection risk (PDR), and how?
A:
🔹 Acceptable audit risk ↑ → ↑ PDR
🔹 Inherent risk ↑ → ↓ PDR
🔹 Control risk ↑ → ↓ PDR
🔹 Higher assessed risks overall (IR or CR) ↓ PDR
🔹 More persuasive audit evidence required ↓ PDR
🔹 Stronger assessed internal controls ↑ PDR
🔹 Lower acceptable audit risk ↓ PDR
🔸 Reminder: The auditor sets PDR based on assessed levels of the other three risks
Q: 🔹 What is materiality, and how is it determined and used in an audit?
A:
🔸 Materiality is the maximum misstatement that can exist without affecting users’ decisions
🔸 Used to:
🔹 Plan the audit
🔹 Evaluate misstatements
🔹 Decide if FS are fairly presented
🔸 Depends on professional judgment, based on:
🔹 User needs
🔹 Nature of the client
🔹 Quantitative & qualitative factors
🔸 Quantitative benchmarks:
🔹 5–10% of net income
🔹 0.5–2% of total assets or revenues
🔸 Qualitative factors (may lower materiality):
🔹 Fraud or illegal acts
🔹 Related party transactions
🔹 Impacts earnings trends or key ratios
🔹 Management compensation incentives
🔹 Public company or sensitive users
🔸 Performance materiality is set below overall materiality to reduce audit risk
Q: 🔹 What are tests of controls, and when are they used?
A:
🔸 Tests to evaluate the design and operating effectiveness of internal controls
🔸 Used when auditor plans to rely on controls to reduce control risk
🔸 Examples:
🔹 Inspecting documents for approvals
🔹 Observing control activities
🔹 Reperforming control steps
🔹 Testing segregation of duties
Q: 🔹 What are tests of details of balances, and why are they important?
A:
🔸 Audit procedures that test individual balances at the account level for material misstatements directly
🔸 Provide direct evidence on financial statement assertions (e.g., existence, valuation)
🔸 Used when:
🔹 Risk of material misstatement is high
🔹 Analytical procedures are not precise enough
🔸 Focused on ending balances, especially high-risk ones like:
🔹 Accounts receivable
🔹 Inventory
🔹 Payables
🔹 Accruals
🔸 Often involve:
🔹 Confirmations
🔹 Recalculations
🔹 Inspection of source documents
Q: 🔹 What is a substantive audit strategy, and when is it used?
A:
🔸 Auditor plans to place no reliance on internal controls
🔸 Control risk is assessed as high, so the auditor performs only substantive procedures
🔸 Used when:
🔹 Controls are weak, absent, or not testable
🔹 Cost of testing controls outweighs benefits
🔸 Focus is on:
🔹 Tests of details
🔹 Substantive analytical procedures
Q: 🔹 What is a combined audit strategy, and when is it used?
A:
🔸 Auditor plans to rely on internal controls and perform tests of controls
🔸 Control risk is assessed as below maximum, allowing reduced substantive testing
🔸 Used when:
🔹 Controls are strong and efficiently testable
🔹 Reliance on controls improves audit efficiency
🔸 Audit work includes:
🔹 Tests of controls
🔹 Substantive procedures (reduced in scope)
Q: 🔹 What are analytical procedures, and when are they used in an audit?
A:
🔸 Analytical procedures involve evaluating financial information by comparing expected vs. actual relationships and identifying unusual fluctuations
🔸 Common techniques:
🔹 Ratio analysis
🔹 Trend analysis
🔹 Reasonableness tests (e.g., depreciation, payroll)
🔸 Used at three stages of the audit:
🔹 Planning – to identify areas of potential misstatement
🔹 As substantive procedures – to gather audit evidence (if predictable & reliable)
🔹 Final review – to assess overall FS consistency and reasonableness
🔸 More effective when:
🔹 Accounts have predictable patterns
🔹 Relationships are well understood
🔹 Auditor can develop reliable expectations
🔸 If used substantively, auditor must:
🔹 Develop an independent expectation
🔹 Compare to actual results
🔹 Investigate significant differences
🔹 Document the process and conclusions
Q: 🔹 What do sufficiency and appropriateness mean in relation to audit evidence?
A:
🔸 Sufficiency = the quantity of evidence
🔹 Affected by:
🔸 Risk of material misstatement (↑ risk → ↑ evidence needed)
🔸 Quality of evidence (higher quality may reduce amount needed)
🔸 Appropriateness = the quality of evidence
🔹 Based on:
🔸 Relevance (does it relate to the assertion tested?)
🔸 Reliability (how trustworthy is the source?)
🔸 The auditor must balance both to support the audit opinion
