Chapter 4 - Audit Planning II

What is audit risk (AR)?

The risk of giving an inappropriate audit opinion when the financial statements are materially misstated.

What is an example of audit risk?

The auditor gives a clean opinion even though the statements contain a material error or fraud.

Can audit risk be zero?

No. The auditor plans and performs the audit to bring it down to an acceptably low level.

How does planning help reduce audit risk?

The auditor identifies key risks and directs more audit effort to accounts and assertions most at risk.

What are management assertions?

Claims about how financial statement items are recognized, measured, presented, and disclosed.

What is an example of an inventory existence assertion?

The inventory recorded on the balance sheet actually exists.

What is the audit risk formula?

AR = IR × CR × DR.

What makes up the risk of material misstatement (RMM)?

Inherent risk and control risk. In the audit risk model, RMM = IR × CR.

Where is risk of material misstatement assessed?

At the financial statement level and the assertion level.

What is inherent risk (IR)?

How susceptible an assertion is to material misstatement before considering internal controls.

What is control risk (CR)?

The risk that the client’s controls fail to prevent, or detect and correct, a material misstatement on time.

What is detection risk (DR)?

The risk that the auditor’s procedures miss a material misstatement that exists.

What is a significant risk?

A risk of material misstatement near the upper end of the inherent risk spectrum, or one another auditing standard requires the auditor to treat as significant.

What transaction or estimate features can increase inherent risk?

Fraud, subjective judgments, and estimates with high uncertainty or complexity.

What information or business changes can increase inherent risk?

Complex data processing or calculations, accounting rules open to interpretation, and major changes such as mergers or acquisitions.

What does the auditor look for when assessing controls for a high-risk account?

Whether the client has controls designed to address the risks for that account and its related assertions.

What determines how much detailed testing an account needs?

The risks in the account and its assertions, and the effectiveness of the client’s controls.

Which audit risk component can the auditor adjust through audit procedures?

Detection risk. More effective procedures reduce the chance of missing a material misstatement.

If combined IR and CR are high, what happens to acceptable DR?

It goes down. The auditor needs more persuasive evidence, typically through more detailed substantive testing.

If combined IR and CR are low, what happens to acceptable DR?

It can be higher. The auditor can rely less on detailed substantive procedures.

What makes information material?

Its misstatement or omission could influence decisions made by financial statement users.

Where does the auditor use materiality?

In planning, testing, and evaluating the information and misstatements in the financial statements.

What is qualitative materiality?

Materiality based on the nature or circumstances of an item. Even a small amount can matter.

What are examples of qualitative materiality factors?

Fraud, legal non-compliance, related-party transactions, and changes in accounting methods or operations.

What is quantitative materiality?

Materiality based on size, usually calculated by applying a percentage to a relevant benchmark.

What is the formula for overall materiality using a benchmark?

Overall materiality = chosen benchmark × selected percentage.

What materiality range does the deck give for normalized pre-tax profit?

3–7%.

What materiality range does the deck give for total assets?

1–3%.

What materiality range does the deck give for equity?

3–5%.

What materiality range does the deck give for revenues or expenditures?

1–3%.

How does the auditor choose a materiality benchmark and percentage?

Use professional judgment based on the client and what matters to financial statement users.

What is performance materiality?

An amount below overall materiality used to plan testing and lower the chance that uncorrected and undetected misstatements together exceed overall materiality.

What performance materiality range does the deck give?

60–75% of overall materiality may be appropriate. Use professional judgment.

How do you calculate performance materiality?

Performance materiality = overall materiality × chosen percentage. At $100,000 overall materiality and 70%, it is $70,000.

What is specific materiality?

A threshold for a particular balance, transaction class, or disclosure where smaller misstatements could influence users’ decisions.

Does higher audit risk automatically lower materiality?

No. Materiality is based on what could influence users. The auditor considers both audit risk and materiality when assessing the risk of material misstatement.

What does the overall audit strategy establish under CAS 300?

The audit’s scope, timing, and direction. It guides the detailed audit plan.

What preliminary assessments help shape the audit strategy?

Inherent risk and control risk.

What is a predominantly substantive approach?

An approach used when control risk is high. The auditor relies heavily on substantive tests of transactions and balances, with little or no testing of controls.

Under a predominantly substantive approach, must the auditor still understand controls?

Yes. CAS 315 requires the auditor to obtain an understanding of the relevant control system even when the auditor generally does little or no control testing.

What must the auditor consider about controls when a significant risk is identified?

Understand the controls relevant to that risk. Inadequate controls may indicate a deficiency worth reporting.

When does the auditor use a combined strategy?

When assessed control risk is low and acceptable detection risk is higher. The auditor combines tests of controls with substantive procedures.

What happens to substantive testing in a combined strategy?

It can be reduced when effective controls support reliance. Some substantive testing is still required for every client.

When does a combined strategy call for extensive control testing?

When the auditor plans to rely on controls and the cost of testing them is warranted.

What are the first two steps in the audit strategy flowchart?

Understand how transactions flow, then identify what could go wrong from initiation through recording in the general ledger.

After identifying what could go wrong, what does the auditor check?

Whether a control can address the risk and whether that control actually exists.

If a control exists and the auditor plans to rely on it, what comes next?

Test whether it operates effectively. Effective controls can reduce reliance on detailed substantive procedures.

What if a control is missing or ineffective?

Increase reliance on detailed substantive procedures and communicate the control weakness as appropriate.

Who receives reports of control weaknesses in the deck’s flowchart?

Management receives reports of control weaknesses. Those charged with governance also receive reports of significant weaknesses.