A3 - Risk, Evidence, and Sampling

Why is the auditor required to perform risk assessment procedures, starting with obtaining an understanding of the entity and its environment?

To assess the risk of material misstatement and to make informed judgements about other audit matters such as:

• Materiality and TM

• The entity’s selection and application of accounting procedures

• Areas that require special audit consideration

• Design and performance of further audit procedures

What risk assessment procedures should the auditor use to obtain an understanding of the entity and its environment?

• Inquiry

• Analytical procedures

• Risk assessment discussion

• Audit data analytics

• Other procedures when applicable, such as review of external information, information obtained during client acceptance or continuance, information obtained on other engagements performed of the entity (ex. consulting engagement), or prior year evidence

The auditor should design and perform risk assessment procedures in a manner that is not biased towards being…

corroborative evidence over contradictory evidence

What are some factors an auditor should obtain an understanding of regarding the nature of the entity?

In general:

• organizational structure

• ownership and governance

• business model

• extent to which the use of IT is integrated into the operations of the entity

Issuers:

• read public information

• observe or read transcripts of earnings calls and other meetings with investors and ratings agencies

• obtain information from SEC filings and other sources about trading activity in the entity’s securities and holding of significant shareholders

• compensation arrangements of senior management

• inquire of the chair of compensation committee

• policies and procedures for authorization and approval of executive officer expense reimbursement

What factors should be examined when obtaining an understanding of the entity and environment?

• Industry, regulatory, and other external factors

• Applicable financial reporting framework

• Technological factors

• Supply chain and economic factors

• The nature of the entity

• Objectives, strategies, and business risks

• The entity’s financial performance

• The company’s selection and application of accounting principles

For what purposes are analytical procedures used in the audit planning phase?

To understand the client’s business and to identify unusual transactions and events, amounts, ratios, or trends that might represent specific risks relevant to the audit

consists of multiple layers of supporting IT infrastructure; different layers include hardware, software, network, operating systems, and data storage

IT environment

IT infrastructure components include…

• hardware

• software

• networks

• operating system

• data storage/databases

List government policies and actions that an auditor may consider.

• Government spending

• Government taxation

• Interest rates

• Political stability

• Requirements for licenses and permits

the rise and fall of economic activity relative to its long-term growth trend; consist of economic fluctuations that vary in duration and severity; some are mild, others are caused by large increases in unemployment and/or inflation

business cycle

What are the phases of a typical business cycle?

1. Expansionary phase

2. Peak

3. Contractionary phase

4. Trough

5. Recovery

characterized by rising growth in economic activity (real GDP)

expansionary phase

high point of economic activity

peak

characterized by declining growth in economic activity

contractionary phase

low point of economic activity

trough

economic activity starts to increase and return to its long-term growth trend

recovery phase

usually predict economic activity and tend to change before the economy follows that trend (ex. orders for goods)

leading indicators

generally follow economic activity and change after an economic trend has already begun (ex. prime rate charged by banks)

lagging indicators

change at about the same time as the economic trend (ex. industrial production)

coincident indicators

Detective controls that review changes in account balances due to business process activities

reconciliations

Visual representation of how information flows through a process

flowcharts

Written documents that tell the story of a process

process narrative

What are 5 inherent limitations that may exist even with an effective internal control system?

1. Human error or faulty/biased judgement used in decision making

2. Issues pertaining to the suitability of the entity’s objectives

3. External events beyond the control of the entity

4. Management override of controls

5. Deliberate circumvention of controls through collusion

The use of information technology affects the way transactions are…

initiated, recorded, processed, and reported

An entity’s use of information technology affects both…

1. D&I of the system of internal control

2. the audit procedures used to gather evidence

What factors change supply (shift the curve)?

ECOST

E: Expectations of price decreases means a firm will supply more now at current price levels

C: Costs (Price of Inputs) - when costs of inputs decrease, supply increases

O: Changes in Price or Demand for Other Goods - D (obsolete), S (new model); decreases in demand for another good offered by the firm will lead to the firm shifting resources toward supplying other remaining goods

S: Changes in subsidies or taxes - increase in government subsidies or decrease in taxes will increase supply

T: Changes in Production Technology - technology improvements will increase supply

What factors change demand (shift the curve)?

SPINE

• Changes in income/wealth - increases in income and wealth increase demand for normal goods

• Changes in price of related goods (substitutes and complements) - If price of a similar good increases (competitors), the demand will increase for the original good; If the price of a complementary good decreases, the demand will increase for the original good

• Changes in consumer tastes or preferences for a product

• Changes in consumer expectations (related to price) - expectations of price increases mean a customer will demand more now at current price levels

• Changes in the number of buyers served by the market - an increase in the number of buyers will increase the demand

a measure of how sensitive the demand for, or the supply of, a product is to a change in price

elasticity

the percentage change in quantity demanded driven by the percentage change in price

price elasticity of demand

A product is considered price elastic demand wise when more _________ are available.

substitutes

the percentage change in quantity supplied driven by the percentage change in price

price elasticity of supply

A product is considered price elastic supply wise when…

products are stored easily

the percentage change in the quantity demanded (or supplied) of one good caused by the price change of another good

cross elasticity

measures the percentage change in quantity demanded for a product given percentage change in income

income elasticity

For normal goods, as income increases…

demand increases

For inferior goods, as income increases…

demand decreases

occurs when the level of production is such that marginal revenue is equal to marginal cost

profit maximization

At what point does total revenue exceed total cost by the largest amount?

Marginal revenue is equal to marginal cost

What is an example of an company that is less affected by business cycles? How about more affected?

hospitals; real estate

What are the indicators of the expansionary phase?

• Rising economic activity

• Rising profits

• Strong growth

• Increased demand

• Rising prices

• Lower unemployment

What are the indicators of the peak?

• Profits are at their highest level

• Firms are facing capacity constraints

• Input shortages leads to higher costs and higher price levels

What are the indicators of the contractionary phase?

• Slowing (or decreasing) growth

• Reduced demand

• Falling profits

• Higher unemployment

What are the indicators of the trough?

• Profits are at their lowest levels

• Firms have excess capacity

• Firms must reduce costs and their workforce

What are the indicators of the recovery phase?

• Rising demand

• Profit stabilization

• Increase in employment

two consecutive quarters of falling national output (GDP); firms profits fall and experience excess capacity

recession

very severe recession; a relatively long period stagnation in business activity, as well as high unemployment rates

depression

• Average consumer expectations for business conditions

• Average weekly hours (manufacturing)

• Average weekly unemployment insurance initial claims

• Bond yield curve [increase is good]

• Building permits for new private residences

• Interest rate spreads (10yr treasury bonds versus federal funds rate) [if government increases the fed funds rate, that means in the future the economy will contract]

• ISM index of new orders

• Leading credit index

• Manufacturers’ new orders for nondefense capital (non-aircraft) orders

• S&P 500 stock index

• The Producer Price Index (PPI) [slight increase is healthy]

examples of leading indicators

• industrial production

• manufacturing and trade sales

• Gross Domestic Product (GDP)

examples of coincident indicators

• Average price rate changed by banks

• Average duration of unemployment

• Commercial and industrial loans outsourcing

• Consumer price index (CPI) for services [change of prices over time]

• Ratio of consumer installment credit to personal income

• Changes in labor cost per unit of manufacturing output

• Inventories-to-sales ratio

examples of lagging indicators