Chapter 5: Audit Risk

What steps are involved on analytical procedures?

*Develop expectation* of account (or ratio) balance Determine amount of *difference that can be accepted* without investigation *Compare* the company's account (ratio) with the expectation *Investigate* and evaluate significant differences

What business characteristics are indicative of high inherent risk?

*Inconsistent profitability* of client Operating results highly *sensitive* to economic factors *Going concern* problems Large known and likely misstatements detected in prior audits Substantial turnover, questionable reputation, or inadequate accounting skills of management

What are the 8 types of audit procedures?

*Inspection* of records and documents, *Inquiry* of knowledgeable persons within or outside the entity, *External confirmation*, *Inspection* of tangible assets, *Observation* of processes or procedures being performed by others, *Recalculation* of mathematical accuracy, *Reperformance* of procedures, and Analytical procedures

What are the presentation and disclosure assertion? Give an example

Accounts are described and classified in accordance with generally accepted accounting principles, and financial statement disclosures are complete, appropriate, and clearly expressed. All information is included in 10K and disclosers are made in correct way

What are accounting estimate transactions?

Activities that create accounting estimates, and they have higher inherent risk

What are the Completeness assertion? Give an Inventory example

All assets, liabilities, equity interests, and transactions that should have been recorded have been recorded Opposite of Existence. Do they include ALL inventory

What are the Valuation, allocation, and accuracy assertion? Give an Sales example

All transactions, assets, liabilities and equity interests are included in the financial statements at proper amounts They may have recorded a sale at the right value for each account

Substantive procedures include

Analytical procedures Tests of details, which includes: Tests of account balances, Tests of classes of transactions, and Tests of disclosures

What are the three types of assertions?

Assertions about account balances (Accounts) Assertions about classes of transactions and events (Transactions) Assertions about presentation and disclosure (Disclosures)

What are the existence/occurrence assertion? Give an Inventory example

Assets, liabilities, and equity interests exist and recorded transactions have occurred. Do they all listed inventory reliably

Names some of working papers.

Audit administrative working papers *Working trial balance*: A schedule listing account balances for the current and previous years, and columns for adjusting and reclassifying entries proposed by the auditors to arrive at the final mount that will appear in the financial statement *Lead schedules*: A schedule set up to combine similar general ledger accounts, the total of which appears on the working trial balance as a single amount Adjusting journal entries and reclassification entries Supporting schedules Analysis of a ledger account Reconciliations Computational working papers Corroborating documents

What kind of evidence must auditors obtain? what qualifies evidence to be this kind?

Auditor must obtain sufficient appropriate audit evidence. To be appropriate audit evidence must be relevant and reliable

Which two risks make up the risk of material misstatement?

CR and IR

What is the relationship between control risk, detection risk, and inherent risk?

CR x DR x IR= AR

Types of working files

Current files: Current year working papers, including Index and cross-referencing Permanent files: Items of continuing audit interest

Companies with high inherent risk affect audits by having:

Difficult to audit transactions or balances Complex calculations Difficult accounting issues Significant *judgment* by management *Valuations* that vary significantly based on *economic factors*

Related party transactions

Disclosure requirements must be met Primary challenge is identifying undisclosed related party transactions Determine related parties Inquiries of management Review SEC filings, stockholder's listings and conflict-of-interest statements Be alert for transactions with related parties and any transactions with unusual terms

Audit documentation should be sufficient to:

Enable an experienced auditor to understand the work performed and the significant conclusions reached Identify who performed and reviewed the work Show that the accounting agree or reconcile to the financial statements Audit documentation should include all significant audit findings and the actions taken to address them

What are the six types of assertions?

Existence or Occurrence, Rights and Obligations, Completeness, Cutoff, Valuation Allocation and Accuracy, and Presentation and Disclosure

What are nonroutine transactions?

Involve activities that occur only periodically such as the taking of physical inventories. They have high inherent risk

What are the three level of inputs used to apply fair value techniques?

Level 1 - inputs of observable quoted prices in active markets for identical assets or liabilities Level 2 - inputs of observable quoted prices, generally for similar assets or liabilities in active markets Level 3 - inputs that are unobservable for the assets or liability

What are the four types of ratio analysis'?

Liquidity (e.g., current ratio) Leverage (e.g., debt to equity) Profitability (e.g., gross profit percentage) Activity (e.g., inventory turnover)

One can change the scope of audit procedures by changing what?

Nature (type and form) Timing (when performed) Extent (quantity of evidence obtained) (NET)

What factors affect inherant risk?

Nature of the client, its environment, and a particular financial statement element

Holding the extent of procedures constant, one may increase the scope of procedures by:

Nature—obtain more reliable evidence. Externally generated evidence is often more reliable than internally generated evidence. Timing—wait until year-end to obtain evidence from entire set of transactions as contrasted to performing interim testing, say two months prior to year-end and simply updating those procedures.

Give 5 examples that indicate that Evidence is more reliable.

Obtained from knowledgeable independent *sources outside the company* rather than nonindependent sources Generated internally through a system of *effective controls* rather than ineffective controls. Obtained *directly by the auditor* rather than indirectly or by inference Documentary in *form rather than oral* Provided by *original documents rather than copies*

What are the primary and secondary functions of audit documentation?

Primary functions are to Support the auditors' compliance with auditing standards and to support the auditors' opinion Secondary functions include: Assist continuing and new audit team members in planning and performing the audit Serves as a record of matters of continuing audit interest Assists in supervision and review of the audit Demonstrates the accountability of team members Assists internal reviewers, external peer reviewers, PCAOB inspectors, and successor auditors in performing their roles

How do they develop an expectation?

Prior period information, Anticipated results, Relationships among elements of financial information within a period, Industry information, or Relationships between financial information and relevant nonfinancial data.

What are routine transactions?

Recurring financial statement activities recorded in the accounting records in the normal course of business. They have lower inherent risk

What are Financial Statement Assertions?

Relevant assertions are those that, without regard for controls, have a reasonable possibility of containing a material misstatement

What are the basic approach to auditing accounting estimates?

Review and test management's process for developing the estimate. Independently develop an estimate to compare to management's estimate. Review subsequent events or transactions bearing on the estimate.

What is the timing of analytical procedures?

Risk assessment (sometimes referred to as planning analytical procedures) Substantive procedures Final review

What is inherent risk?

Risk of a material misstatement occurring in an assertion assuming no related internal controls.

What is control risk?

Risk that a material misstatement in an assertion will not be prevented or detected on a timely basis by the company's internal control.

What is detection risk?

Risk that the auditors' procedures will lead them to conclude that a material misstatement does not exist in an assertion when in fact such misstatement does exist.

What are the three types of transactions?

Routine Nonroutine Estimation transactions

What are the Rights and Obligations assertion? Give an A/R example

The company holds rights to the assets, and liability are the obligations of the company Company has the right/legal title of a certain A/R

Holding other factors such as the nature and timing of procedures constant:

The greater the risk of material misstatement, the greater the needed extent of substantive procedures The main way to increase the extent of audit procedures is to examine more items Sample sizes should reduce detection risk so as to restrict audit risk to a low level

What is audit risk?

The possibility that the auditors may unknowingly fail to appropriately modify their opinion on financial statements that are materially misstated (auditors will issue an unqualified opinion on financial statements that contain a material departure from GAAP). Auditors must obtain sufficient appropriate audit evidence to reduce audit risk to a low level in every audit.

What are substantive procedures?

To detect material misstatements at relevant assertion level. Substantive procedures include (a) analytical procedures, (b) tests of details of account balances, transactions and disclosures

What are risk assessment procedures?

To obtain an understanding of the client and its environment, including its internal control, to assess the risks of material misstatement

What are the Cutoff assertion? Give an Sales example

Transactions and events have been recorded in the correct accounting period Allocating certain sales transactions in the right period

What are the two types of expectation?

Trend analysis—analyze changes in accounts of a company over time Ratio analysis — compare relationships between two or more financial statement accounts or comparisons of account balances to nonfinancial data

What are tests of controls?

When appropriate, to test the operating effectiveness of controls in preventing material misstatements