module 2
If audit risk is set at 1.6%, inherent risk is 80%, and control risk is 80%, what should auditors set for detection risk? And, what is the best audit strategy?
2.5%, substantive approach
Payables turnover in days
365 / (cost of sales/ average acc payable) -Measures how many days, on average, it takes to pay suppliers. smaller number wanted
Inventory turnover in days
365/ (cost of sales/ average inventory) -Measures how many days, on average, it takes to sell inventory. smaller number wanted
what best exemplifies the incentives and pressures to commit a fraud and the opportunities to perpetrate it?
A significant decline in demand for the client's products or services is an example of incentives and pressures faced by client personnel to commit a fraud. However, this example in no way indicates that a fraud has definitely occurred.
Which of the following statements is correct regarding analytical procedures?
Analytical procedures are important to the auditor because they allow the auditors to compare their own expectations to the client's performance by analyzing relationships between data, both financial and non-financial.
Analytical procedures.
Auditors analyze a client's financial information using ratios and trend analysis.
when are comparisons done?
Comparisons are often made between account balances for the current year and the previous year(s), the current year and the budget, or the current year and industry data.
Integrity of Management negatives
Concerns exist about the integrity of management in business and accounting decisions. Management is preoccupied with meeting specific accounting numbers.
what is representative of the risk response phase of an audit?
Decision on whether the auditor can rely on the effectiveness of the client's internal controls
___ refers to the amount of time spent gathering audit evidence, whereas ____refers to minimizing audit risk.
Efficiency; effectiveness
Which of the following is the least likely to result in a higher inherent risk assessment?
Entity sells high-quality products and has a low rate of return.
assertions
Expressed or implied representations by management regarding the recognition, measurement, presentation, and disclosure of information in the financial statements and related disclosures.
Which is an example of fraud and exemplifies the kind of fraud committed? I. Capitalizing items that should be expensed is part of Fraudulent Financial Reporting II. Inappropriate application of accounting principles is part of Misappropriation of Assets III. Writing checks to fictitious vendors is part of Fraudulent Financial Reporting IV. Employees remaining on the payroll after ceasing employment is part of Misappropriation of Assets
IV. Employees remaining on the payroll after ceasing employment is part of Misappropriation of Assets
Independence negatives
Independence and conflict of interest issues exist that cannot be resolved prior to client acceptance.
In conducting analytical procedures, which of the following information sources are generally considered to be reliable? -Audited information from an accounting firm that was fired by the company earlier this year -Information from a source internal to the client that has not yet been proven to be accurate -Information generated by an independent reputable external source -Information generated using inconsistent accounting methods
Information generated by an independent reputable external source
Explain how internal performance reports may be used by auditors to assess the risk of material misstatement.
Internal performance reports, such as budgets and other comparisons, may be used by auditors to gain a deeper understanding of the accounts potentially at risk of material misstatement.
Which of the following statements is correct regarding related party transactions?
Life insurance policies purchased by the client company are related party transactions that should be monitored.
integrity of management positives
Management shows integrity in business and accounting decisions. Management places a premium on representational faithfulness of accounting information.
Which of the following descriptions best captures the term "profit margin"?
Measures the profitability of a company after accounting for all operating expenses
A large, profitable social media client has hired you to perform an audit of the company's financials. The client has briefed you on some of the firm's key performance indicators. Which of the following is likely NOT one of the social media client's KPIs?
Sales per passenger mile - is it likely with Net new customers per quarter Earnings per share Cash flow from operations
overconfidence bias
Tendency to overestimate one's own ability to make accurate assessments of risk or other judgments or decisions.
Which of the following is the biggest risk associated with the client's closing procedure?
The client capitalized expenses instead of recognizing them when they incurred for the period.
the CPA has an audit client with a very active presence on social media. Which inherent risk is most likely to be considered?
The content that is being promoted in social media.
An auditor is deciding whether or not to accept a new client. Which of the following best synthetizes a potential acceptance by the auditor when analyzing a client's integrity?
The prospective client has a good reputation, including management, directors, and key stakeholders. Management has a positive attitude toward the implementation and maintenance of adequate internal controls. Managers are willing to allow the auditors full access to client personnel, records, and information required to form their opinion.
During a recent economic downturn, when the economy as a whole is poor and the entire industry is down, you as an auditor are concerned that the management may face pressures, prompting them to "take a bath" to make the company appear less profitable than it actually is. What measures should you look at first?
Understating revenue and overstating expenses
A similarity between the performance gap and the expectation gap is that both gaps
are from auditing standards and regulations.
An auditor mistakenly concludes that a company is financially sound based on an incorrect appraisal of the company's pension obligations. This best exemplifies which of the following risks?
audit risk
Regression Analysis
can be used to investigate the relationships among different groups of data or variables.
entity-level risk
client risk that affects multiple financial statement accounts, assertions, and transaction classes
transaction-level risk
client risk that affects only one transaction class, account, or assertion
are typically evaluated during the risk assessment phase
corporate governance. compliance with laws and regulations. related parties.
When RMM is high (the control and inherit risk)
the DR is low, and then inverse as well
Why would the auditors adopt a reliance on controls approach?
when internal controls are effective, and the auditors can perform less extensive detailed substantive procedures at year-end.
Acid-test (quick) ratio
(cash + short-term investments + current receivables AKA liquid assets) / current liabilities -Measures ability to meet short-term obligations with liquid assets such as cash, short-term investments, and receivables. want close or more than 1.0
A major stockholder paying back a loan at period end, and the company lending the same amount of money back to the stockholder shortly after the quarter ends, is an example of which of the following?
Period-end window dressing
significant risk
an identified and assessed risk of material misstatement that, in the auditor's judgment, requires special audit consideration
Which of the following involve the identification of fluctuations in accounts that are inconsistent with the auditors' expectations based upon their understanding of the client?
analytical procedures
Time-Series Analysis
can be used to analyze data that occur regularly within the client, like sales and purchases.
Quantitative Factors
can impact a user's decision-making because of their dollar magnitude in the financial statements.
Analytical procedures are required during which phase of the audit?
risk assessment and conclusion
Explain four incentives and pressures that increase the risk of fraud.
(1) the client operating in a highly competitive industry, (2) a significant decline in demand for the client's products and services, (3) failing profits, and (4) a threat of takeover.
describe factors that the auditor should gain an understanding of while in the Risk Assessment Phase
-the nature and history of the entity, including its operations, revenue sources, products, services, markets served, key personnel, locations, ownership structure, business investments underway or planned, key customers, key suppliers and its financing structure. -relevant external factors affecting the entity like the general economic conditions, interest rates and the availability of finance. -the factors at play in the industry sector in which the entity operates, like market size, level of competition, supplier and customer relationships.
Analytical procedures are performed in what order?
1-During risk assessment. Analytical procedures are used to aid in the risk identification process. 2- During risk response. Analytical procedures are an efficient method of gathering evidence about the fair presentation of account balances. 3- At the audit's conclusion. Analytical procedures are used to assess whether the financial statements reflect the auditors' knowledge of their client and the client's industry.
Receivables turnover in days
365/ (net credit sales/ average net receivables) -Measures how many days, on average, it takes to collect cash from customers. small number wanted
What is a debt covenant?
A debt covenant is an agreement with a lender in which a company promises to maintain specified profitability, liquidity, or other financial ratios, or to seek the lender's permission before taking on new borrowings or acquiring other companies.
observations
A great way to learn more about a client is to observe its operations. To learn more about a client's products, take a tour of the client's production line to see how the products are made. To learn more about how payroll transactions are processed, observe the process happening in the payroll department.
When regarding risk assessment, what is correct?
AU-C 300 Planning an Audit and AS 2101 Audit Planning require auditors to plan the audit by assessing risk to reduce audit risk to an acceptably low level.
Which standards provide audit guidance associated with related party transactions and disclosures?
AU-C 550 and AS 2410
Which of the following alternatives best synthesizes the purpose of developing an audit strategy?
Audit strategy is the process by which auditors determine the most appropriate scope, direction, and timing of audit engagement. An audit strategy also helps to develop an audit plan for the success of audit engagement, as well as set the right audit approach.
Inquiry
Auditors spend considerable time inquiring, or asking questions, of client personnel about operations and accounting processes. Auditors also inquire of groups that transact business with the client, such as customers, vendors, and lenders.
inspection
Auditors spend considerable time inspecting, or reading and reviewing, documents.
In comparing a company's account balances, which of the following is the auditor generally NOT concerned with?
Current year versus the next year -it is concerned with Current year versus the industry average Current year versus the previous year Current year versus the average of years over the past 10 years
Matthews Grocery Stores has transitioned to new accounting software for accounts payable. Which of the following inherent risks should be considered by the auditors?
Data could be lost when transferring from the old system to the new one.
Net operating cycle
Gross operating cycle − Payables turnover in days -Measures how many days, on average, it takes to purchase and sell inventory, collect the receivable, and pay creditors.you want smaller
Factors to Consider When Conducting Analytical Procedures: Reliability of client data.
If auditors feel there is significant risk that the client's records are unreliable due to poor internal controls, then they are less likely to rely on analytical procedures.
Factors to Consider When Conducting Analytical Procedures: Past results are unaudited.
If past data is unaudited, it is less reliable for comparison purposes.
Factors to Consider When Conducting Analytical Procedures: Ability to make comparisons over time.
If the client has changed accounting methods, it will reduce the comparability of the underlying data. Auditors will need to restate prior years' financial data using the current accounting methods before making any comparisons.
Which of the following statements is correct regarding a client's relations with its employees?
More complex payroll systems represent higher inherent risk.
independence positive
No independence problems exist, or independence problems can be resolved prior to client acceptance.
why is the risk assessment phase important?
risk assessment phase optimizes efficiency and effectiveness when conducting an audit
Are procedures to identify related parties only performed during risk assessment?
Procedures to identify related parties may be performed outside of risk assessment because auditors should always be mindful of potential related parties. Client circumstances could change and new relationships could be created at any time during the client's year.
how can you overcome bias?
Proper training of audit staff. Supervision of audit staff Review of audit work performed.
Gross operating cycle
Receivables turnover in days + Inventory turnover in days -Measures how many days, on average, it takes to purchase inventory, sell it, and collect the receivable.you want small
phases of an audit
Risk Assessment Phase Risk Response Phase Reporting Phase
automation bias
Tendency to favor output generated from automated systems, even when human reasoning or contradictory information raises questions about whether such output is reliable or fit for purpose.
availability bias
Tendency to place more weight on events or experiences that immediately come to mind or are readily available than on those that are not.
confirmation bias
Tendency to place more weight on information that corroborates an existing belief than on information that contradicts or casts doubt on that belief.
anchoring bias
Tendency to use an initial piece of information as an anchor against which subsequent information is inadequately assessed
what is correct regarding audit opinions?
The audit does not guarantee the future viability of the entity.
A client sells concrete pipe and has a high-voltage fence surrounding the pipe inventory. Inherent risk is low for the assertion of inventory existence because concrete pipe is very heavy and difficult to move. It is unlikely that recorded pipe quantities do not exist. After testing that the security system is working and has been operational throughout the year, the auditor can set control risk low. What is the best alternative for the auditor if one wants to keep audit risk low?
The auditor will set a high detection risk and spend less time performing audit procedures
Why is it important that the board of directors have a mixture of executive and non-executive members?
The executive members have a deeper understanding of the company and its workings, whereas the non-executive members may be better representatives of shareholders and can be more impartial in their strategic decision-making.
Which of the following best exemplifies the incentives and pressures to commit a fraud, and the opportunities to perpetrate it?
The existence of opportunities to commit a fraud does not mean that fraud has definitely occurred. Hence, auditors must use professional judgment to assess each opportunity in the context of other risk indicators and consider available evidence thoroughly.
Competence issues negatives
The firm does not have expertise needed to provide the full scope of services requested by the client, or does not have affiliation with specialists to meet client needs.
competence issues positive
The firm has expertise to perform services requested by the client or has access to specialists that can meet client needs.
Special circumstance and unusual risks positives
There are minimal regulatory reporting requirements. The client is financially stable and profitable, with no significant concerns about debt covenants. No scope limitations exist. The entity has a strong accounting system with effective internal controls.
Special circumstance and unusual risks negatives
There are significant regulatory reporting requirements with close monitoring by regulators. The client is experiencing profitability issues, weak cash flows, and is close to violation of debt covenants. The client voices significant concerns about the scope of audit work. The entity has an ineffective accounting system with few internal controls.
Suspendus Company has the following financial data for the year ended December 31, 2021: net sales $1,680,000, operating expenses $880,000, net income $104,000, stockholders' equity $800,000, and assets $1,901,000. The information for the year ended December 31, 2020 was: net sales $1,450,000, operating expenses $760,000, net income $87,000, stockholders' equity $700,000, and assets $1,601,000. Calculate the gross profit margin for the year ended December 31, 2021.
There is not enough information to answer the question.
Debt-to-equity
Total Debt/Total Equity -Measures the relative proportion of equity and debt used to finance total assets.
The planning materiality threshold for company A is $300 million and auditors decided that one-third of that amount, $100 million, is an appropriate performance materiality threshold at the account level to determine if individual accounts or transactions are materially misstated. Generally, auditors would spend minimal time performing detailed audit testing on all accounts EXCEPT
Valuation Allowance - $50M.
indirect effect
a situation in which noncompliance with laws and regulations does not have a direct impact on amounts and disclosures in the financial statements, but could require the creation of a contingent liability or an additional disclosure
performance materiality
amount or amounts set by the auditors at less than the materiality level for particular classes of transactions, account balances, or disclosures
what is a related party?
an affiliate, principal owner, manager, or other party that is not independent of the entity.
current ratio
current assets/current liabilities -Measures ability to meet short-term obligations as they come due. want more than 1.0
direct and material effect
effect a situation in which noncompliance with laws and regulations impacts amounts and disclosures already included in the financial statements
Which of the following is NOT a commonly used procedure in audit data analytics (ADA), where auditors use software to conduct detailed analyses of client data?
factor analysis
risk assessment phase
gaining an understanding of the client, identifying risk factors, setting a materiality level, and developing an audit strategy
Qualitative Factors
if it affects a user's decision-making process for a reason other than its magnitude.
reliance on controls approach
if you can answer yes to all 3, then go this route Yes #1. There is an internal control, or several, that can mitigate the inherent risk factor. But has the client put a control in place? In other words, does the control exist? Yes #2. The client does have a control in place to mitigate the inherent risk factor. However, just because a control is in place does not mean the control is actually working. The next step is for auditors to test the control during the interim time period. (How these controls are tested will be covered in Chapter 8.) The results of the auditors' tests of controls will reveal if the control is working and is effective. Yes #3. If results from the tests of controls confirm the control is effective at preventing and/or detecting material misstatements, the auditors will conclude that control risk is low and overall RMM is low. Note that an effective internal control can offset a high inherent risk.
Which type of risk would most likely be affected by a client having a limited number of major customers?
inherit risk
risk response phase
involves detailed testing of internal controls, transactions, account balances, and disclosures the auditors have determined to be at high risk of material misstatement
reporting phase
involves drawing conclusions based on the evidence gathered and arriving at an opinion regarding the fair presentation of the financial statements why
If audit risk is set at low, inherent risk is medium, and control risk is high, what should auditors set for detection risk?
low
Price/Earnings (P/E) Ratio
market price per share/ earnings per share -Shows how much a stockholder is willing to pay per dollar of earnings.
Marcie, a member of the audit team, discovers during a conversation with a client that the marketing agency used by the client is owned by the spouse of the VP of Operations. Recognizing this as a related party relationship, Marcie and the audit team must exercise professional skepticism and identify all of the following risks EXCEPT
material risk -they would on disclosure risk. fraud risk. risk that the relationship and related transactions were not properly authorized.
key performance indicators (KPIs)
measurements, agreed to beforehand, that can be quantified and reflect the success factors of an organization
In which of the phases does the auditor start identifying factors that may impact the risk of a material misstatement occurring in the financial statements?
risk assessment
If audit risk is set at low, inherent risk is high, and control risk is low, what should auditors set for detection risk?
medium, dr is inverse of the cr and ir
Times interest earned
net income/ interest expense -Measures ability of earnings to cover interest payments.
Earnings per share (EPS) ratio
net income/shares outstanding -Reflects the earnings return on each common share issued.
Cash earnings per share (CEPS) ratio
operating cash flow/ outstanding stocks -shows the cash flow capacity of a company for each common share outstanding
Audit Strategy
provides the basis for developing an audit plan that details the nature, extent, and timing of the audit procedures that will be performed
engagement letter
sets out the terms of the audit engagement to avoid any misunderstandings between the auditor and the client
Cluster Analysis
statistical techniques identify groups of entities that have similar characteristics
If the auditor determines that inherent risk and control risk are high, the best audit strategy to use is the
substantive approach
if you can answer no to all, go this route No #1. If there is no internal control that can mitigate the risk factor, then both inherent risk and control risk are high. Therefore, RMM is high. No #2. There is an internal control, or several, that can mitigate the inherent risk factor, but the client has not put any controls in place. Therefore, RMM is high. No #3. The client does have a control in place; therefore, the auditor tests the control to determine if it is working effectively. Results from the tests of controls reveal the client's control is not working effectively. Therefore, RMM is high.
substantive approach
cash flow from operations adjusted for one-time influences
sustainable cash flow from operations
Sustainable free cash flow
sustainable cash flow from operations − Capital expenditures -Measures the cash flow remaining after covering cash outflows for operations and capital expenditures. want big number
Ability of cash flow from operations to cover current debt and dividends
sustainable cash flow from operations/ current portion of financing debt + dividends -Measures ability to cover current debt maturities and dividends with operating cash flow. want big number
Solvency
the ability of a company to meet its long-term financial obligations
liquidity
the ability of a company to pay its current debts when they fall due
materiality
the ability of information to influence the judgment made by a reasonable user based on the financial statements
Describe the audit strategy used when the auditor adopts a predominantly substantive approach.
the audit strategy is to increase detailed substantive procedures performed at year-end.
The audit expectation gap is caused by unrealistic user expectations. What example would not be included in an unrealistic user expectations?
the auditor provides reasonable assurance.
nature of the audit
the determination of what type of audit procedure to use, such as tests of controls or substantive procedures
Control Risk (CR)
the risk that a client's system of internal controls will not prevent or detect a material misstatement on a timely basis
audit risk
the risk that an auditor expresses an inappropriate audit opinion when the financial statements are materially misstated
Detection Risk (DR)
the risk that the auditor's testing procedures will not be effective in detecting a material misstatement
risk of material misstatement (RMM)
the risk that the financial statements are materially misstated prior to the audit; a combination of inherent risk and control risk
inherent risk (IR)
the susceptibility of an assertion to a misstatement that could be material, either individually or when aggregated with other misstatements, before consideration of any related controls
extent of an audit
this audit procedure the determination of the quantity (how much) of audit procedures to be performed
substantive procedures (substantive testing or tests of details)
this audit procedures designed to detect material misstatements at the account and assertion level
test of control
this audit procedures designed to evaluate the operating effectiveness of controls in preventing, or detecting and correcting, material misstatements at the assertion level
timing of an audit
this procedure the determination of when an audit procedure is to be performed
Which of the following describes why an auditor may use internal performance reports to assess the risk of material misstatement?
to indicate which accounts might be most at risk for material misstatement
In a common-size analysis, which line item on the balance sheet is most likely to be used for comparing account balances?
total assets
While auditing Anastasia General Merchandise Corporation, what can Alex Young, CPA, use as a benchmark for prepaid expense, and property, plant, and equipment accounts?
total assets
Information technology is typically included in which of the following processes?
transaction initiation
what is a trend analysis and why use it?
trend analysis is a comparison of account balances over time. its used to show movements in accounts and if it matches what their understanding of the client and their operations is
T/F Auditing standards require auditors to perform analytical procedures during risk assessment as part of the risk identification process, even if the data are preliminary or aggregated at a high level
true
t/f Audit risk is the risk that an auditor expresses an inappropriate audit opinion when the financial statements are materially misstated.
true
what all occurs during the risk assessment phase
understand the entity and the industry preliminary analytical procedures. assess fraud risk.
Where Does Data Analytics Fit In?
using a technology tool to perform audit data analytics on a large data set is the best way to analyze information, auditors have lots of information to go through so they must be smart on how to chose which data to use
audit data analytics (ADA)
using software to discover and analyze patterns, identify anomalies, and extract other useful information in data underlying the subject matter of an audit through analysis, modeling, and visualization for the purpose of planning or performing an audit