Audit Exam 2

Audit Risk Model Steps

- Set a planned level of audit risk such that an opinion can be issued on the financial statements. - Assess the risk of material misstatement (IR x CR). - Use the audit risk equation to solve for the appropriate level of detection risk:

Misappropriation of Assets Attitudes/Rationalizations

- Disregard the need for monitoring or reducing risks related to theft - Disregard for internal control over misappropriation of assets by overriding existing controls or by failing to correct known internal control deficiencies - Changes in behavior that may indicate assets have been misappropriated

Audit Program

A set of audit procedures prepared to test assertions for a component of the financial statements are referred to as an audit program. An example: An audit program for Accounts Receivable may test the existence assertion by sending confirmations, test the rights and obligations assertion by inquiring of management whether or not the receivables have been sold, test the completeness assertion by agreeing the total of the accounts receivable subsidiary ledger to the accounts receivable control account, and test the valuation assertion by testing the adequacy of the allowance for doubtful accounts.

Vouching

More aggregated information to less aggregated information for existence/occurence Vouching is agreeing a journal or ledger to the source documents and tests the occurrence assertion

FRR Opportunities

Nature of the Industry or entity's operations Complex or unstable org structure Deficient Internal Controls Ineffective monitoring or management

Test of Controls

Necessary for estimating RMM Necessary for audit internal controls in integrated audit Sampling

Valuation or Allocation (PCAOB)

Assets, liabilities and recorded transactions have been valued in accordance with GAAP

Audit Risk Model

Audit Risk = (Inherent Risk x Control Risk) x Detection Risk

The Auditor's Risk Assessment Process

Auditors perform risk assessment procedures to obtain an understanding of the entity and its environment. This understanding helps the auditor identify business risks and understand the potential misstatements that may result. Considering the response of the entity to the business risk leads the auditor to assess the risk of material misstatement at the financial statement and assertion level

Sampling

Becoming more automated and professional judgement is becoming more of the focus

Completeness (PCAOB)

All balances and transactions have been recorded in the financial statements

Misappropriation of Assets Opportunities

- Large amount of cash on hand - Access to assets susceptible to theft or misappropriation - Inadequate internal controls - Inadequate supervision

FRR Attitudes and Rationalizations

- Nonfinancial management's excessive participation in selection of accounting principles and estimates - Ineffective communication of ethical standards or selection of inappropriate ethical standards - Excessive interest by management in stock prices and earning trends - Recurring attempts to justify marginal or inappropriate accounting based on materiality - Committing to aggressive or unrealistic forecasts - History of violations of securities laws or allegations of fraud

Existence or Occurence (PCAOB)

Assets and liabilities included in the accounts exist and recorded transactions are valid and have actually occurred

Misappropriation of Assets Incentives/Pressures

- Personal financial obligations - Adverse relationships between entity and employee

Examples of misstatements include:

-An inaccuracy in gathering or processing data from which financial statements are prepared. -An omission of an amount or disclosure. -A financial statement disclosure that is not presented in accordance with GAAP. -An incorrect accounting estimate arising from overlooking or clear misinterpretation of facts. -Judgments of management concerning accounting estimates that the auditor considers unreasonable or accounting policies that the auditor considers inappropriate.

Risk of Material Misstatement

= Inherent Risk x Control Risk inverse relationship to detection risk An increase in RMM necessitates a decrease in detection risk

Functions of documentation

1 To provide support for the audit report. 2 To aid in the planning, performance, and supervision of the audit. 3 To provide a focal point for reviewing work of subordinates; to provide a basis for quality reviews. ...Also... 4) feedback and learning!

4-27 Required: For each illustration, select the component of audit risk that is most directly illustrated. The components of audit risk may be used once, more than once, or not at all. Control risk Detection risk Inherent risk 1. A client fails to discover employee fraud on a timely basis because bank accounts are not reconciled monthly. 2. Cash is more susceptible to theft than an inventory of coal. 3. Confirmation of receivables by an auditor fails to detect a material misstatement. 4. Disbursements have occurred without proper approval. 5. There is inadequate segregation of duties. 6. A necessary substantive audit procedure is omitted. 7. Notes receivable are susceptible to material misstatement, assuming there are no related internal controls. 8. Technological developments make a major product obsolete. 9. The client is very close to violating debt covenants. 10. XYZ Company, a client, lacks sufficient working capital to continue operations.

1. A 2. C 3. B 4. A 5. A 6. B 7. C 8. C 9. C 10. C

5-35 Required: a. Classify each document as internal or external evidence. b. Classify each document as to its reliability (high, moderate, or low). 1. Duplicate copies of sales invoices. 2. Purchase orders. 3. Bank statements. 4. Remittance advices. 5. Vendors' invoices. 6. Materials requisition forms. 7. Overhead cost allocation sheets. 8. Shipping documents. 9. Payroll checks. 10. Long-term debt agreements.

1. Duplicate copies of sales invoices. a. Internal b. Low to moderate 2. Purchase orders. a. Internal b. Low unless strong internal controls 3. Bank statements. a. External b. High 4. Remittance advices. a. External b. High 5. Vendors' invoices. a. External b. High 6. Materials requisition forms. a. Internal b. Low unless strong internal controls 7. Overhead cost allocation sheets. a. Internal b. Low unless strong internal controls 8. Shipping documents. a. Internal b. Low unless strong internal controls 9. Payroll checks. a. Internal b. Low unless strong internal controls (higher than others though because have to be certified by manager) 10. Long-term debt agreements. a. External b. High

IIASB Account Balance Assertions

1. Existence 2. Rights and Obligations 3. Completeness 4. Accuracy/Valuation, and Allocation 5. Classification 6. Presentation

PCAOB Assertions

1. Existence or Occurrence 2. Rights and Obligations 3. Completeness 4. Valuation and Allocation 5. Presentation and Disclosure

Fraud Risk Triangle

1. Incentive / pressure 2. Opportunity 3. Rationalization / attitude

IIASB Transaction Assertions

1. Occurrence 2. Completeness, Cutoff 3. Authorization 4. Accuracy/Valuation, and Allocation 5. Cutoff 6. Classification 7. Presentation

Assurance Bucket

1. Risk Assessment Procedures 2. Test of Controls 3. Substantive Analytical Procedures 4. Remaining assurance needed from tests of details stack up evidence in that order until desired assurance is achieved

Types of Fraud

1. fraudulent financial reporting 2. misappropriation of assets

5-34 Required: For each situation, indicate whether the first or second type of evidence is more reliable. Provide a rationale for your choice. a. A bank confirmation versus observation of the segregation of duties between cash receipts and recording payment in the accounts receivable subsidiary ledger. b. An auditor's recalculation of depreciation versus examination of raw material requisitions. c. A bank statement included in the entity's records versus shipping documents. d. Physical inspection of common stock certificates held for investment versus physical examination of inventory components for a personal computer.

A. Bank confirmation is more reliable because of external third party and reduction of measure management B. Recalculation is more reliable due to direct personal knowledge C. Bank statement is more reliable because it is external D. Physical inspection of common stock is more reliable because the stock certificates are prepared by an entity external to the client. Additionally, the auditor may not be able to easily determine the quality or value of the computer components.

5-36 Required: a. List the factors that affect the reliability of confirmations. b. One of the allegations in a recent fraud was that confirmations of account balances to various banks were determined to be forgeries. Auditing standards state that "an audit rarely involves the authentication of documentation, nor is the auditor trained as or expected to be an expert in such authentication." What steps could the auditors have taken to ensure that bank confirmations were reliable? c. Refer back to EarthWear Clothiers' financial statements included after Chapter 1. Identify any information on EarthWear's financial statements that might be verified through the use of confirmations.

A. external vs internal, prior experience with firm, nature of information, independent respondent, positive vs negative confirmation B. Confirm the recipient was legit and the validty of the third party. Adequate internal controls as well will help mitigate this issue. C. Cash balance (bank), AR Balance (individual customer), collateral for loan, AP (vender), inventory.

Which assertion? Assets, liabilities, and equity interests have been included in the financial statements at appropriate amounts, and any resulting valuation or allocation adjustments have been appropriately recorded, and related disclosures have been appropriately measured and described.

Accuracy valuation / allocation

Presentation and Disclosure (PCAOB)

All accounts are presented in the appropriate place and all information required has been disclosed in the statements and footnotes

Appropriateness

Appropriateness is a measure of the quality of audit evidence. Based on relevance and reliability

Valuation and Allocation (Accuracy or Valuation) KQ

Are the accounts valued correctly? Are expenses allocated to the period(s) that were benefited?

Completeness (Completeness, Cutoff) KQ

Are the financial statements (including footnotes) completed? Were all transactions recorded? Are transactions included in the proper period?

Recalculation

Checking the mathematical accuracy of documents or records.

Risk Assessment Procedures

Client Acceptance Planning Understanding Client Inquiries / board docs Analytical Procedure required Corroborating evidence not required

Which assertion? Agree total of accounts receivable subsidiary ledger to accounts receivable control account.

Completeness

Which assertion? The accounts and transactions that should be included are included; thus, the financial statements are complete.

Completeness

Inquiry

Discussions with key (primarily client) personnel

Existence or Occurence (Existence, Occurence) KQ

Do the assets listed really exist? Did the recorded sales transactions really occur?

Rights and Obligations (Rights and Obligations) KQ

Does the company really own the assets? Are all legal responsibilities to pay the liabilities identified?

Rights and Obligations (PCAOB)

Entity has a legal claim on all assets and revenues reported and has a legal responsibility for all liabilities and expenses

Analytical Procedure

Evaluations of financial information made by a study of plausible relationships among both financial and nonfinancial data.

Inspection of Documents and Records

Examining source papers, files, schedules, reconciliations Evidence obtained from external documents is more reliable than evidence obtained from internal documents.

FFR Incentives/Pressures

Excessive pressure for management to meet third party expectations Financial stability or profitability is threatened Management's personal financial situation is threatened

Which assertion? Confirm accounts receivable.

Existence

Which assertion? The assets and liabilities exist, and the recorded transactions have occurred.

Existence or occurence

5-38 At December 31, 2018, EarthWear has $5,890,000 in a liability account labeled "Reserve for returns." The footnotes to the financial statements contain the following policy: "At the time of sale, the company provides a reserve equal to the gross profit on projected merchandise returns, based on prior returns experience." The entity has indicated that returns for sales that are six months old are negligible, and gross profit percentage for the year is 42.5 percent. The entity has also provided the following information on sales for the last six months of the year: Required: a. Using the information given, develop an expectation for the reserve for returns account. Because the rate of return varies based on the time that has passed since the date of sale, do not use an average historical return rate. b. Determine a tolerable difference for your analytical procedure. c. Compare your expectation to the book value and determine if it is greater than tolerable difference. d. Independent of your answer in part (c), what procedures should the auditor perform if the difference between the expectation and the book value is greater than tolerable misstatement?

Expectation - find weighted average Step 2 - threshhold is 50% of PM or 1% of recorded accounut balance Step 3: Compare Conclude that it is safe

Reliability Rankings

Highest reliability: Inspection of tangible assets, reperformance, recalculation Mid-level reliability: Inspection of records and documents, confirmation, analytical procedures, scanning Lowest Reliability: Observation, inquiry

Lowest external document reliability?

If related party transaction

Reliability

Independent source outside the entity Effectiveness of internal control Auditors direct personal knowledge (most reliable) Documentary evidence Original documents

Audit Evidence

Inspection of Tangible Assets Inspection of Documents Observation Confirmation Inquiry Scanning Analytical Procedures Reperformance/Recalculation

Scanning

Judgmentally review accounting data to identify significant or unusual items to test.

Fraudulent Financial Reporting (FFR)

Lying Examples: - Manipulation, falsification, or alteration of accounting records or supporting documents used to prepare financial statements. - Misrepresentation in, or intentional omission from, the financial statements of events, transactions, or significant information. - Intentional misapplication of accounting principles relating to amount, classification, manner of presentation, or disclosure.

5-31 For each management assertion, indicate an example of a misstatement that could occur for revenue transactions. Occurrence. Completeness. Authorization. Accuracy. Cutoff. Classification. Presentation.

Occurrence: Revenue received before goods are shipped (gift card) Completeness: Entity fails to record valid transaction revenue Authorization: Credit risk of customers not within the threshold Accuracy: Revenue amount recorded incorrectly Cutoff: 2019 sale recorded in 2018 Classification: Other revenue as operating revenue Presentation: Unusual details related to revenue not disclosed as they should be

Highest internal document reliability ?

Payroll

Inspection of Tangible Assets

Physical examination of assets (e.g., fixed asset additions, CIP).

Which assertion? Inquire of management whether receivables have been sold.

Rights and obligations

Which assertion? The assets are the rights of the entity, and the liabilities are its obligations.

Rights and obligations

Audit Procedures

Risk Assessment Procedures Test of Controls Substantive Procedures

Not sure

Risk Assessment Procedures Tests of Account Balances Test of Transactions Analytical Procedures Test of Controls Test of Disclosures

5-39 Required: Compare The Home Improvement Store's ratios with those of its industry. You may want to reference the advanced module in this chapter for more information regarding the ratios used in the analytical procedure. For each ratio provided in the table above a. Indicate the potential risks the ratio and/or historical patterns may present. b. Indicate one or two plausible explanations for why The Home Improvement Store's ratios or historical patterns differ from those of the industry.

Quick ratio decreasing for entity but increasing for rest of industry - potential liquidity issues. Low ratio may signal period of high growth or recently repayment of large debt. Days of inventory on hand - the higher the ratio the longer it takes to sell inventory, could signal that they are becoming obsolete if going up Inventory / CA increasing could singal huge increase in inventory, coupled with increase in quick ratio could signal rapid expansion Return on Assets (ROA) below industry averafe signals that the company is not getting as hgih returns as competitors and poses going concern issue or they could be rapidly expanding and therefore experiencing short term earnings decreases Debt to Equity Ratio increased but leveled off, could signal rapid expansion that is cooling down. Also the stock price could have dropped due to lower earnings making the only outlet for raising capital be debt

Entity Business Risks

Reporting and performance risks

•What would you use as the population to sample from if you were performing tests of details on AR for completeness?

Sample from sales prior to year-end and trace to recording in GL or Sample from subsequent cash receipts and check to see that it was included in AR

Reducing Opportunity

Segregation of duties

Sufficiency

Sufficiency is the measure of the quantity of audit evidence. Greater risk of misstatement requires a higher quantity of audit evidence. Higher quality audit evidence results in a lower quantity of audit evidence.

Substantive Procedure

Testing of financial statements Detail testing Sampling Analytical procedure not required but is the most extensive Corroborating evidence required

Relevance

Testing the right assertion ?

Reperformance

The auditor's independent execution of procedures or controls that were originally performed by company personnel.

Audit documentation (working papers)

The auditor's record of the audit procedures performed, evidence obtained, and conclusions reached. •Audit documentation should be organized so that audit team members and others can find evidence supporting financial statement accounts. •All audit documentation is the property of the auditor, including documents prepared by the entity at the auditor's request. •The Sarbanes-Oxley Act of 2002 requires audit documentation to be retained for a number of years from the completion date of the engagement.

Identifying and Reducing Pressure

The first step to preventing fraud is paying careful attention to changes in employees' personal and financial circumstances. Note that the triangle uses the term "pressure," rather than "incentive," to emphasize that people are far more motivated to avoid losses than simply to improve their lot. Few frauds arise just because an employee wants a nicer car or a bigger house. Don't we all? Frauds far more commonly arise because an employee faces financial or personal difficulties likely to result in a loss of wealth, status, or employment. Effective fraud prevention starts with watching for "red flags" that indicate such losses are possible. Common indicators include substance abuse, divorce, major new expenses (often associated with family members' health needs), and poor job performance. Firms can also prevent fraud by not imposing unnecessary pressures in the workplace. Some observers attribute Enron's culture of fraud to their "rank-and-yank" system of performance evaluation, which required managers to rank the performance of their employees and fire the ones in the lowest categories. While such systems can motivate employees to work harder, they can also motivate them to consider maintaining their present position via less noble means.

Confirmation

The process of obtaining a representation of information or of an existing condition directly from a third party. •The reliability of evidence obtained through external confirmations may be affected by factors such as: •The form of the confirmation (positive vs. negative). •Prior experience with the entity. •The nature of the information being confirmed. •The intended respondent. Some information is frequently confirmed by auditors, such as cash balances, accounts receivable, inventory on consignment, accounts payable, bonds payable, common stock outstanding, insurance coverage, and collateral for loans. Note: Some audit evidence counts as more than one procedure. For example, confirmations of AR would involve the audit procedures of "Inspection of documents" and "Confirmation"

Observation

The process of watching a process or procedure being performed by others

Engagement Risk

The risk that the auditor is exposed to financial loss or damage to his or her professional reputation from litigation, adverse publicity, or other events arising in connection with financial statements audited and reported on.

Misappropriation of Assets

Theft Misappropriation of assets involves the theft of an entity's assets to the extent that financial statements are misstated. Stealing, paying for goods not received by company, embezzling

Purpose of Analytical Procedure: Final Procedures

Used as an overall review of the financial information in the final review stage of the audit. Required Corroborating evidence required as well. If the auditor cannot find sufficient evidence within the working papers, the auditor would formulate possible explanations, conduct additional testing, and seek an explanation from the entity's personnel.

Purpose of Analytical Procedure: Risk Assessment

Used to assist the auditor to better understand the business and to plan the nature, timing, and extent of audit procedures. Required Corroborating evidence is not required

Purpose of Analytical Procedure: Substantive

Used to obtain evidential matter about particular assertions related to account balances or classes of transactions. Not required but when done they are the most thorough in this stage

Which assertion? Test the adequacy of the allowance for doubtful accounts.

Valuation or allocation

Presentation and Disclosure (Classification, Understandability) KQ

Were all the transactions recorded in the correct accounts? Are the disclosures understandable to users?

Negative Confirmation

a form sent to a customer by auditors requesting that the customer respond only if the balance shown on it is incorrect

Positive confirmation

a letter sent to a customer by auditors requesting that the customer respond whether the balance shown on it is correct or not

5-32 For each of the following specific audit procedures, indicate the type of audit procedure it represents: (1) inspection of records or documents, (2) inspection of tangible assets, (3) observation, (4) inquiry, (5) confirmation, (6) recalculation, (7) reperformance, (8) analytical procedures, and (9) scanning. a. Sending a written request to the entity's customers requesting that they report the amount owed to the entity. b. Examining large sales invoices for a period of two days before and after year-end to determine if sales are recorded in the proper period. c. Agreeing the total of the accounts receivable subsidiary ledger to the accounts receivable general ledger account. d. Discussing the adequacy of the allowance for doubtful accounts with the credit manager. e. Comparing the current-year gross profit percentage with the gross profit percentage for the last four years. f. Examining a new plastic extrusion machine to ensure that this major acquisition was received. g. Watching the entity's warehouse personnel count the raw materials inventory. h. Performing test counts of the warehouse personnel's count of the raw material. i. Obtaining a letter from the entity's attorney indicating that there were no lawsuits in progress against the entity. j. Tracing the prices used by the entity's billing program for pricing sales invoices to the entity's approved price list. k. Reviewing the general ledger for unusual adjusting entries.

a. Confirmation (BS) b. Inspection of records (IS) c. Inspection of records (BS) or reperformance d. Inquiry (BS) e. Analytical procedure f. Inspection of physical g. Observation h. Reperformance I. Inspection of records j. Inspection of recrods k. Scanning

5-33 For each of the audit procedures listed in Problem 5-32, identify the category (assertions about classes of transactions and events or assertions about account balances) and the primary assertion being tested.

a. Existence b. Cutoff c. Completeness d. Allocation/accuracy e. Allocation/valuation f. Completeness / existence g. Completeness / existence h. Completeness / existence I. Completeness/accuracy j. Accuracy k. Accuracy

Tracing

source document and follows its processing path FORWARD to find its final recording in a summary journal or ledger. (completeness)

Sue Sachdeva

•Embezzled a total of $34M from Koss corporation to pay for her personal credit card •American Express helped catch her activities. Amex noticed that she was paying for large balances with wire transfers from a Koss account. •Purchases in question included $382,400 at two jewelry stores and $1.4 million at one clothing boutique (much of her clothing and jewelry purchases were never opened or worn) •Sentenced to 11 years in prison, served 6, remains liable for restitution •a future of garnished wages and tax refunds awaits

Communications About Fraud

•- matter should be brought to the attention of an appropriate level of management •- fraud involving senior management and fraud that causes a material misstatement of the financial statement should be reported directly to the audit committee Auditor is prohibited (by confidentiality) from disclosing fraud to outside parties unless... •To comply with certain legal and regulatory requirements •To a successor auditor when the successor makes inquiries of the predecessor auditor about the client •In response to a subpoena •To a funding agency or other specified agency in accordance with requirements for the audits of entities that receive governmental financial assistance

In conducting inquiry, the auditor should:

• Consider the knowledge, objectivity, experience, responsibility, and qualifications of the individual to be questioned. • Ask clear, concise, and relevant questions. • Use open or closed questions appropriately. • Listen actively and effectively. • Consider the reactions and responses and ask follow-up questions. • Evaluate the response.

Audit Risk Model Limitations

• The desired level of audit risk may not actually be achieved. • It does not consider potential auditor error. • There is no way of knowing what the preliminary level of risk of material misstatement actually was.

Which part of the fraud triangle do organizations have the most control over?

•Opportunity •What can they do? •It is essential that organizations build processes, procedures (e.g., performance measurement systems) and controls that do not needlessly put employees in a position to commit fraud and that effectively detect fraudulent activity if it occurs. Tone at top and compensation

Opportunity

•Opportunity relates to physical access (missappropriation of assets), or the ability to commit FRF

Pressure and Incentive

•Pressure is a "need" felt by the person who commits fraud •Incentives = financial/reputational benefit

Rationalizations/attitudes

•Relates to "tone at the top" and/or a presence or history of excessive participation in financial reporting by nonfinancial management •What sort of perspective does management have? (attitude) •How might someone talk themselves into thinking the fraud is okay? (rationalization)

Audit Risk

•Risk of issuing "clean" (unqualified) audit opinion on material misstated financial statements The biggest driver to engagement risk

Control Risk

•Risk of material misstatement getting past internal controls • •Specific to the client's systems and processes •Think of CR and DR as lines of defense against the RMM making its way to the financial statements •Control Risk = the risk that internal controls will not prevent or detect RMM

Detection Risk

•Risk of not detecting a material misstatement that occurred and got past internal controls •How do we reduce this? •By doing more (or better) procedures •i.e., by auditing more •"Set" by the auditor •The auditor assesses/measures IR and CR, then sets DR to achieve the desired level of Audit Risk •Think of CR and DR as lines of defense against the RMM making its way to the financial statements •Detection Risk = the risk that the auditor will not detect a RMM that exists (i.e., inherent risk) and is not prevented or detected by controls (i.e., control risk)

•What would you use as the population to sample from if you were performing tests of details on AR for existence?

•Sample from GL and vouch to subsequent cash receipt

Key Concepts ARM

•The auditor cannot affect inherent risk or control risk. The auditor can only ASSESS them. •The auditor can only affect detection risk—generally by examining more evidence. •And by setting detection risk, the auditor also sets audit risk •Detection risk is inversely related to control risk and inherent risk. •Detection risk is inversely related to competence and reliability of evidence. •Detection risk is positively related to materiality

4-28 For each of the following situations, explain how risk of material misstatement should be assessed and what effect that assessment will have on detection risk. a. Johnson, Inc., is a fast-growing trucking company operating in the southeastern part of the United States. The company is publicly held, but Ivan Johnson and his sons control 55 percent of the stock. Ivan Johnson is chairman of the board and CEO. He personally makes all major decisions with little consultation with the board of directors. Most of the directors, however, are either members of the Johnson family or long-standing friends. The board basically rubber-stamps Ivan Johnson's decisions. b. MaxiWrite Corporation is one of several companies engaged in the manufacture of high-speed, high-capacity data storage devices. The industry is very competitive and subject to quick changes in technology. MaxiWrite's operating results would place the company in the second quartile in terms of profitability and financial position. The company has never been the leader in the industry, with its products typically slightly behind the industry leader's in terms of performance. c. The First National Bank of Pond City has been your client for the past two years. During that period you have had numerous arguments with the president and the controller over a number of accounting issues. The major issue has related to the bank's reserve for loan losses and the value of collateral. Your prior audits have indicated that a significant adjustment is required each year to the loan loss reserves.

•a. Domination of decision making by one individual increases IR. Rapid expansion increases IR. RMM = higher, set detection risk lower. • •b. Competitive industry with rapidly changing technology increases IR. Less profitable company increases IR. RMM = higher, set detection risk lower. • •c. Unfamiliar client with history of contentious relations and material misstatements = higher IR. RMM = higher, set detection risk lower.

4-26 You are considering acceptable audit risk at the financial statement level. For each of the following independent scenarios, based only on the information provided, indicate the effect on acceptable audit risk compared to a typical private company audit. Page 122 LVD is a pharmaceutical company that has three successful drugs. They have recently decided to make a public offering of their stock. Budd Co., a private company, has approached your audit firm to bid on their annual audit. During discussions with the CFO, you learn that the company is filing for bankruptcy. Stephens Inc., a private company, has recently installed a new accounting information system.

•a. Higher engagement risk = lower planned/acceptable audit risk • • • •b. Higher engagement risk = lower planned/acceptable audit risk • • •c. Higher control risk = lower detection risk to achieve normal level of audit risk

Inherent Risk

•the risk of RMM before considering related internal controls •Risk of material misstatement existing/occurring whether caused by error or fraud • •Exists due to •The nature of the client's business or industry •e.g., financial services client with high risk transactions •the nature of the account balance •e.g., cash is susceptible to theft