Ch. 4

Why should auditors understand their clients' performance measures when assessing inherent risk?

It's to determine what information management and others deem to be key indicators of company performance that may affect the risk of material misstatement.

What are the five steps involved with the use of preliminary analytical procedures?

1) Develop an expectation. 2) Define a significant difference. 3) Compare expectation with the recorded amount. 4) Investigate significant differences. 5) Document each of the preceding steps.

What is the purpose of an audit strategy memorandum? What information should it contain?

An audit strategy memorandum is the scope, timing, and direction for auditing each relevant assertion based on the results of the audit risk model.

What is the auditor's responsibility regarding fraud risk?

Auditors are only concerned with fraud only as it affects the financial statements.

What are some types of knowledge and understanding about a client's business and industry that an auditor is expected to obtain? What are some of the methods and sources of information for understanding a client's business and industry?

Auditors should read public information about the company. They also need to obtain an understanding of compensation arrangements with senior management. General business sources, company sources (corporate charter, contracts), information from previous audits from predecessor auditors.

What are some of the ratios that can be used in preliminary analytical procedures?

Balance-sheet ratios, operations ratios, and financial distress ratios.

What is the primary difference between a material misstatement due to fraud or error?

Errors are usually unintentional, while fraud is intentional.

How do the professional audit standards differ for errors, frauds, direct-effect noncompliance, and indirect-effect noncompliance?

Errors, Fraud, Direct-Effect Noncompliance--produce direct and material effects on financial statement amounts, require reasonable assurance that there are no material misstatements. Indirect-Effect Noncompliance--violations of laws and regulations that aren't directly connected to financial statements, auditors are not required to provide assurance for these noncompliances unless it could possibly have material effect on financial statements.

Define audit risk.

It is the possibility that an audit team will express an inappropriate audit opinion when the financial statements are materially misstated. Audit Risk = Inherent risk * Control risk * Detection risk

What is meant by the terms "nature, timing, and extent" of further audit procedures?

Nature--the type of procedure and the purpose of the procedure. Timing--when the audit procedures will be completed. Extent--the number of tests performed.

What is the purpose of performing preliminary analytical procedures in audit planning?

The auditors are required to develop an expectation about what an account balance should be and then compare the expectation to the recorded balance.

What is the major concern for auditors related to evidence obtained from related parties?

The major concern is that these individuals or organizations can influence or be influenced by decisions of the company, via familial ties or investment relationships.

What are the components of the risk of material misstatement (RMM)? What are the components of the audit risk model?

The two components of RMM are inherent risk and control risk. The components of the audit risk model are inherent risk, control risk, and detection risk.

When are analytical procedures required, and when are they optional?

They are required during the preliminary stages of an audit.

Why is it important for an auditor to carefully assess inherent risk on each audit engagement?

They can allocate more and stronger resources to test specific accounts and disclosures that present a higher likelihood of material misstatement and a higher level of inherent risk.

What are the defining characteristics of white-collar crime, employee fraud, embezzlement, larceny, defalcation, management fraud, and errors?

White-collar crime--usually financial frauds Employee fraud--the use of fraud to misappropriate funds or other property from an employer. Embezzlement--type of fraud involving employees or nonemployees wrongfully misappropriating funds or property entrusted to their care and other forms of deception and cover-up. Larceny--theft. Defalcation--misappropriation of assets; employee fraud, embezzlement, and larceny. Errors--unintentional misstatements or omissions of amounts or disclosures in financial statements.