Chapter 9

Q7 Give 3 potential cause of Planned detection risk?

1. Inappropriate audit procedure 2. Improper or incomplete use of an audit procedure 3. Misinterpreting audit results

Q6. Define Detection Risk, Explain why detection risk exist, and how detection risk can be reduced by auditors?

Detection risk is the risk auditors fail to detect a material misstatement remaining undetected by the auditor. some of the detection risks is always present due to the inherent limitations of the audit. detection risk can be reduced by auditors by increasing the number of sampled transaction for detailed testing.

Q12 An auditor cannot assess the risk of material misstatement without first deciding the size of misstatements that will be considered material. Materiality and audit risk are considered together in planning.

Factors Affecting Preliminary Materiality Judgment: Materiality is a relative rather than an absolute concept. Benchmarks are needed for evaluating materiality. Qualitative factors also affect materiality.

Q4 Name and describe the three types of characteristics of transactions and balances that might cause an auditor to determine that a risk of material misstatement is a significant risk?

1. Nonroutine Transactions: Significant risks often relate to significant nonroutine transactions, which represent transactions that are unusual, either due to size or nature, and that are infrequent in occurrence. Nonroutine transactions may increase the risk of material misstatement because they often involve a greater extent of management intervention, including more reliance on manual versus automated data collection and processing, and they can involve complex calculations or unusual accounting principles not subject to effective internal controls due to their infrequent nature. Related party transactions often reflect these characteristics, thereby increasing the likelihood they are considered significant risks. 2. Matters Requiring Significant Judgment: Significant risks also relate to matters that require significant judgment because they include the development of accounting estimates for which significant measurement uncertainty exists. Classes of transactions or account balances that are based on the development of accounting estimates often require significant judgment that is subjective or complex based on assumptions about future events. As a result, those types of transactions or balances frequently are identified as significant risks. 3. Fraud Risk: Because fraud generally involves concealment, detecting material misstatements due to fraud is difficult. As a result, when auditors identify a potential risk of material misstatement due to fraud, auditing standards require the auditor to consider that risk a significant risk, which triggers required responses to those risks.

Q3 what constitute a significant risk? What do the auditing standards require?

A significant risk represents an identified and assessed risk of material misstatement that, in the auditor's professional judgment, requires special audit consideration. Auditing standards require the auditor to obtain an understanding of the entity's controls relevant to significant risks to evaluate the design and implementation of those controls, and the auditor must perform substantive tests related to assertions deemed to have significant risks.

Q9 List the three major factor categories affecting Acceptable Audit risk and one illustration per category.

Factors Affecting Acceptable Audit Risk: 1. The degree to which external users rely on the statements based on these factors: Client size Distribution of ownership Nature and amount of liabilities 2. The likelihood that a client will have financial difficulties after the audit based on these factors: Liquidity position Profits (losses) in previous years Method of financing growth Nature of the client's operations Competence of management 3. The auditor's evaluation of management's integrity

Q10. List 3 factors to consider when assessing inherent risk?

Factors to Consider when assessing inherent risk: Nature of the client's business Results of previous audits Initial versus repeat engagement Related parties Complex or nonroutine transactions Judgment required to correctly record account balances and transactions Factors related to fraudulent financial reporting Factors related to misappropriation of assets

Q11. Define the term Materiality as it is used in accounting and auditing? What is the relationship between materiality and the phrase "obtain reasonable assurance" as used in the audit report?

Materiality is defined as the magnitude of misstatements that individually, or when aggregated with other misstatements, could reasonably be expected to influence the economic decisions of users made on the basis of the financial statements. "Obtain reasonable assurance," as used in the audit report, means that the auditor does not guarantee or insure the fair presentation of the financial statements. There is some risk that the financial statements contain a material misstatement.

Q8 Explain the relationship between detection risk and the nature, timing and extent of audit testing?

Planned detection risk is the risk that audit evidence for a segment will fail to detect misstatements that could be material, should such misstatements exist. In order to reduce this risk, the auditor would increase the amount of evidence they collect for a specific audit objective. For example, if the auditor wanted a low level of risk that audit procedures designed to test the existence of inventory fail to detect a material misstatement, they would increase the amount of inventory tested and/or the number of audit procedures performed.

Q5 Give the audit risk model, list and defined each of its components. Risk of Material Misstatement is made up of which components?

The audit risk model is as follows: PDR = AAR IR x CR Where PDR = Planned detection risk AAR = Acceptable audit risk IR = Inherent risk CR = Control risk Planned detection risk A measure of the risk that audit evidence for a segment will fail to detect misstatements that could be material, should such misstatements exist. Acceptable audit risk A measure of how willing the auditor is to accept that the financial statements may be materially misstated after the audit is completed and an unmodified opinion has been issued. Inherent risk A measure of the auditor's assessment of the susceptibility of an assertion to material misstatement before considering the effectiveness of internal control. Control risk A measure of the auditor's assessment of the risk that a material misstatement could occur in an assertion and not be prevented or detected by the client's internal controls.

Q2 To obtain an understanding of the entity and its environment, including the entity's internal controls, the auditor performs risk assessment procedures to identify and assess the risk of material misstatement, whether due to fraud or error. What does Risk assessment procedures include? Name the 4 major risk assessment procedures and explain their respective purpose?

The auditor performs risks assessment procedures to identify and assess the risk of material misstatement, whether due to fraud or error. Risk assessment procedures include the following: 1. Inquiries of management and others within the entity: Because management and others, including those charged with governance and internal audit, have important information to assist the auditor in identifying risks of material misstatements, the auditor will make a number of inquiries of these individuals to understand the entity and its environment, including internal control, and to ask them about their assessments of the risks of material misstatements. 2. Analytical procedures: As noted in Chapter 8, auditors are required to perform preliminary analytical procedures as part of audit planning to better understand the entity and to assess client business risks. 3. Observation and inspection: Auditors observe the entity's operations and they inspect documents, such as the organization's strategic plan, business model, and its organizational structure to increase the auditor's understanding of how the business is structured and how it organizes key business functions and leaders in the oversight of day-to-day operations. 4. Discussion among engagement team members: Auditing standards require the engagement partner and other key engagement team members to discuss the susceptibility of the client's financial statements to material misstatement. This includes explicit discussion about the susceptibility of the client's financial statements to fraud, in addition to their susceptibility of material misstatement due to errors.

Q1 Name the two levels where risk of material misstatement can be found and explain the particularity of each? Why do auditors care about The risk of material misstatement? Give an example

The risk of material misstatement exists at two levels: the overall financial statement level and at the assertion level for classes of transactions, account balances, and presentation and disclosures. Auditing standards require the auditor to assess the risk of material misstatement at each of these levels and to plan the audit in response to those assessed risks. The risk of material misstatement at the overall financial statement level refers to risks that relate pervasively to the financial statements as a whole and potentially affect a number of different transactions and accounts. It is important for the auditor to consider risks at the overall financial statement level given those risks may increase the likelihood of risks of material misstatement across a number of accounts and assertions for those accounts. Inherent risk and control risk relate to the risk of material misstatement at the assertion level. A number of overarching factors may increase the risks of material misstatement at the overall financial statement level. For example: deficiencies in management's integrity or competence, ineffective oversight by the board of directors Similarly, declining economic conditions or significant changes in the industry, or A number of overarching factors may increase the likelihood that material misstatements may be present in a number of assertions affecting several classes of transactions, account balances, or financial statement disclosures inadequate accounting systems and records increase. Non routine transactions Highly complex transactions etc