Audit Exam 2

What is the first concept in a financial statement audit?

materality

What is the second concept in a financial statement audit?

audit risk

What is the 3rd concept in a financial statement audit?

evidence

What is the defintion of audit risk?

financial statements are materially misstated and auditors did not detect it

During an audit risk what opinion does the auditor issue?

an unqualified opinion

What are the two levels of audit risk?

financial statement level and assertion level

What level out of the two does the big 4 accounting firms deal with?

financial statement level

What is listed in the assertion level risk?

account balances, classes of transactions, disclosures. management claims about what are listed in accounts

Audit Risk

Assertion Level

What are the two categories associated with this?

risk of material misstatement and detection risk

Risk of Material Misstatement

Client or Audit based risk?

client based risk

Detection Risk

Client or Audit based risk?

audit based risk

What is detection risk?

risk that auditor will not detect misinformation

Assertion Level

Risk of Material Misstatement

What are the two types of risk?

inherent risk and control risk

What is the audit risk formula?

IR= inherent risk

CR= control risk

DR= detection risk

Audit risk= IR *CR *DR

What represents client based risk in audit risk formula (componets)?

IR * CR

What represents audit based risk in audit risk formula (componets)?

DR

What is the audit risk model formula used to assess?

the amount of audit work that you will be doing

What part of the formula is inherent risk and control risk “risk of material misstatement”?

IR * CR

What part of the formula is detection risk?

DR

What is inherent risk?

likelihood of a misstatement BEFORE internal controls factored in

Client Based Risk

Inherent Risks

What is the first inherent risk?

complexity of transactions

Client Based Risk

Inherent Risks

Complexicity of transactions

different categories, depends on what is easy and what is hard

Client Based Risk

Inherent Risks

What is the second inherent risk?

nature of the assets

Client Based Risk

Inherent Risks

Nature of the assets

what are their assets? buildings, plastic pellets, etc

Client Based Risk

Inherent Risks

What is the 3rd inherent risk?

accounting estimates

Client Based Risk

Inherent Risks

Accounting Estimates- what is an example of this?

construction (have to estimate how far they are done to figure out how much revenue to recognize) vs how many packages did we ship?

Client Based Risk

Inherent Risks

What is the 4th risk?

business risks

Client Based Risk

Inherent Risks

Business risks

whats going on in the eoncomy, legal matters, political, etc

Client Based Risk

Inherent Risks

What is the 5th risk?

competence level of management and accounting staff

Client Based Risk

Inherent Risks

Competence level of management and accounting staff

know who you are doing business with

Client Based Risk

Inherent Risks

What is the 6th risk?

financial performance- based compensation

Client Based Risk

Inherent Risks

Financial performance-based compensation

What is an example of this?

bonus- if i do this i get extra money, can lead to more fraud

What is client based risk?

likelihood of a misstatement because internal controls won’t prevent/detect

wasn’t detected because of a problem with internal controls

Client Based Risk

Control Risk

What is the 1st risk?

Technology problems

Client Based Risk

Control Risk

What is the 2nd risk?

lack of control training

Client Based Risk

Control Risk

Lack of control training

do they explain the “why” or are we just going through the motions?

Client Based Risk

Control Risk

What is the 3rd risk?

lack of control compliance

Client Based Risk

Control Risk

Lack of control compliance

tell them to do it but they are not doing it

Client Based Risk

Control Risk

What is the 4th risk?

lack of control compliance checking

Client Based Risk

Control Risk

Lack of control compliance checking

lack of checking to make sure they are doing what they are supposed to be doing

Client Based Risk

Control Risk

What is the 5th risk?

failing to have all appropriate parts in internal control systems

What is audit based risk?

likelihood of auditors not finding the misstatement

What does a low detection level mean?

not willing to accept a high level of risk

Low detection risk= ______ substantive testing

more

Detection Risk

What is nonsampling risk?

didn’t finish audit procedure, didn’t interpret findings correctly, not being independent

What are the two categories of detection risk?

nonsampling and sampling risk

Detection Risk

Sampling risk

didn’t test enough

Engagement Risk

Litigation and Adverse publicity are connected to…

an auditor’s exposure to financial loss and damage to professional reputation

What is another way to write the audit risk formula? (combining) 2

RMM= risk of material misstatement

IR= inherent risk

CR= control risk

DR= detection risk

Audit risk= RMM * DR

What is another way to write the audit risk formula? (combining) 3

RMM= risk of material misstatement

IR= inherent risk

CR= control risk

DR= detection risk

Audit risk= (IR*CR) * DR

Using the Audit Risk Model

What is the 1st step?

set a planned level of audit risk

Using the Audit Risk Model

What is the 2nd step?

assess the risk of material misstatement (IR*CR)

Using the Audit Risk Model

What is the 3rd step?

use the audit risk equation to solve for the appropriate level of detection risk

In the audit risk formula what risk is set last?

detection risk

Detection risk (looking for audit risk formula to get to DR)

CR= control risk

IR= inherent risk

AR= audit risk

DR= AR/(IR*CR)

Relationship of the Entity’s Business Risks to the Audit Risk Model

What is step 1?

audit risk

Relationship of the Entity’s Business Risks to the Audit Risk Model

What is step 2?

What is the first step from this section?

assess the entity’s business risks

Relationship of the Entity’s Business Risks to the Audit Risk Model

What is step 2?

What is the second step from this section?

relate those risks to what can go wrong at the account balance or disclosure level

Relationship of the Entity’s Business Risks to the Audit Risk Model

What is step 2?

What is the 3rd step from this section?

assess the risk of material misstatement (RMM)

Relationship of the Entity’s Business Risks to the Audit Risk Model

What is step 2?

What is the 4th step from this section?

RMM (inherent risk * control risk)

Relationship of the Entity’s Business Risks to the Audit Risk Model

What is step 3?

detection risk

When risk misstatement is higher, detection risk is blank (what you are willing to accept)

lower

If detection risk is low you should

do more audit procedures

Case 1

AR (audit risk) is low

RMM is high

Then DR is

low

Case 2

AR is low

RMM is moderate

DR is

moderate

Case 3

AR is low

RMM is low

DR is

high

Limitations of the Audit Risk Model

Preliminary Assessment Level of Risk- what do you perform on this stage?

perform risk assessment

The Auditor’s Risk Assessment Process

What does the auditor need to do at this stage?

auditors need to identify business risks and understand the potential misstatements that may result

The Auditor’s Risk Assessment Process

What are business risks?

business risks are results that result from significant conditions,events, circumstances or actions that impair management’s ability to execute strategies

Risk Assessment Procedures

What is the 1st step?

inquiries

The Auditor’s Risk Assessment Process

What is the 2nd step?

analytical procedures

The Auditor’s Risk Assessment Process

What is the 3rd step?

observations

The audit risk against which the auditor and those who rely on his/her opinion require reasonable protection is a combination of two separate risks at the assertion level. The first risk (consisting of inherent risk and control risk) is that balances, classes of transactions, or disclosures contain material misstatements. The second is that

A.The auditor will reject a correct account balance as incorrect.

B.Material misstatements that occur will not be detected by the audit.

C.The auditor will apply an inappropriate audit procedure.

D.The auditor will apply an inappropriate measure of audit materiality.

B.Material misstatements that occur will not be detected by the audit.

Audit risk at the assertion level consists of inherent risk, control risk, and detection risk. Which of the following statements is true?

A. Cash is more susceptible to theft than an inventory of coal because it has a greater inherent risk.

B.The risk that material misstatement will not be timely prevented or detected by internal control can be reduced to zero by effective controls.

C.Detection risk is a function of the efficiency of an auditing procedure.

D.The existing levels of inherent risk, control risk, and detection risk can be changed at the discretion of the auditor.

A.Cash is more susceptible to theft than an inventory of coal because it has a greater inherent risk.

The acceptable level of detection risk is inversely related to the

A.Assurance provided by substantive procedures.

B.Risk of misapplying auditing procedures.

C.Preliminary judgment about materiality levels.

D.Risk of failing to discover material misstatements.

A.Assurance provided by substantive procedures.

Which of the following types of risks most likely would increase if accounts receivable are confirmed 3 months before year end?

A.Inherent

B.Control

C.Detection

D. Business

C.Detection

What are errors?

unintentional misstatements amounts or disclosures in the financial statements

What is fraud?

an intentional act by one or more among management, those charged with governance, employees, or third parties, involving the use of deception that results in a misstatement in the financial statements

What is a commonality between errors and fraud?

both expected to find misstatements

What is the first misstatement due to errors or fraud?

an error in gathering or processing data from which financial statements are prepared

What is the 2nd misstatement due to errors or fraud?

an omission of an amount or disclosure

Misstatement due to errors or fraud

Omission of an amount or disclosure includes

inadequate or incomplete disclosures required to meet disclosure objectives of certain financial reporting frameworks

What is the 3rd misstatement due to errors or fraud?

a financial statement disclosure that is not presented in accordance with GAAP

What is the 4th misstatement due to errors or fraud?

an incorrect accounting estimate arising from overlooking or clearly misinterpreting of facts

What is the 5th misstatement due to errors or fraud?

judgements of management concerning accounting estimates that the auditor considers unreasonable or accounting policies that the auditor considers inappropriate

What is the 6th misstatement due to errors or fraud?

an inappropriate classification, aggregation, or disaggregation of information

What is the 7th misstatement due to errors or fraud?

the omission of a disclosure necessary for the financial statements to achieve fair presentation beyond disclosures specifically required by the framework

What are the three parts of a fraud triangle?

rationalization, motivation, and opportunity

What are the 3 conditions that usually exist when fraud occurs?

incentive or pressure to perpetrate fraud, opportunity to carry out the fraud, attitude or rationalization to justify fraud

Risk Factors Relating to Incentive/Pressure

Step 1

excessive pressure for management to meet 3rd party expectations

Risk Factors Relating to Incentive/Pressure

Step 2

financial stability or profitability is threatened

Risk Factors Relating to Incentive/Pressure

Step 3

management’s personal financial situation is threatened

Risk Factors Relating to Opportunities

What is the 1st opportunity?

nature of the industry or entity’s operations

Risk Factors Relating to Opportunities

What is the 2nd opportunity?

ineffective monitoring of management

Risk Factors Relating to Opportunities

What is the 3rd opportunity?

complex or unstable organizational structure

Risk Factors Relating to Opportunities

What is the 4th opportunity?

deficient internal control

Risks Factors Relating to Attitudes/Rationalizations

What is the 1st one?

nonfinancial management’s excessive participation in selection of accounting principles and estimates

Risks Factors Relating to Attitudes/Rationalizations

What is the 2nd one?

ineffective communication of ethical standards or selection of inappropriate ethical standards

Risks Factors Relating to Attitudes/Rationalizations

What is the 3rd one?

excessive interest by management in stock prices and earning rewards

Risks Factors Relating to Attitudes/Rationalizations

What is the 4th one?

recurring attempts to justify marginal or inappropriate accounting based on materality