Chapter 5

Risk of Material Misstatement

Inherent Risk (IR) and Control Risk (CR)

The components of the risk of misstatement are

Inherent Risk, Control Risk, No Detection Risk

Can there be additions and or deletions to audit documentation after completion date

can not delete or discard after completion date, but may add. Need to indicate date added, name of person and reason.

Analysis of a ledger account

changes in assets, liabilities, equities, revenue, or expense during a period. Here is the BB and this is how I got to EB.

Corroborating Documents

minutes of director meetings

Audit administrative working papers

-Audit Plans and Programs -Internal Control questions and flow charts -Engagement Letters -Time and budget

Generalizations about reliability of audit evidence

-Audit evidence is more reliable when obtained from knowledgeable independent sources outside entity -Audit evidence generated internally is more reliable when related controls imposed by entity are effective -Audit evidence obtained directly by auditor is more reliable than evidence obtained indirectly or by inference -Audit evidence more reliable when it exists in documentary form, paper electronic or other medium. -Audit evidence provided by original documents are more reliable than photocopies.

Quality of Audit Evidence

-Strength

Quantity of Audit Evidence

-The sufficiency/ amount Measure of the quantity of audit evidence that should be obtained. The greater risk, the more audit evidence is required.

Use of assertions in obtaining audit evidence in relation with presentation and disclosure

-completeness -classification and understandability -occurrence -accuracy and valuation -rights and obligations

Use of assertions in obtaining audit evidence in relation with classes of transactions and events for period

-completeness -cutoff -classification -occurrence -accuracy

Use of assertions in obtaining audit evidence in relation with account balances

-existence -rights and obligations -completeness -valuation and allocation

Lead Schedules

-grouping sheets, summary schedule. -combine similar general ledger accounts

Supporting Schedules

-listing of elements or detailed comprising a balance A/P- listing of amounts owed to each vendor

Ways good audit documentation proves the quality of work performed

-providing record of actual work performed, providing assurance -facilitating reviews performed by supervisors, managers, engagement partners. -improving effectiveness and efficiency by reducing time consuming explanations.

List the five sources of information that are available to the auditors in developing expectations for analytical procedures.

1. Comparable financial data from prior periods. 2. Industry averages 3. Relationships among elements of financial information within a period 4. Budgets or forecasts 5. Relevant nonfictional information. For example, many operating costs of a trucking business should be related closely to the number of miles driven.

Assertions with high inherent risk involves

1. Difficult to audit transactions or balances 2. Complex calculations 3. Difficult accounting issues 4. Significant judgement by management 5. Valuations that vary significant based on economic factors

Type of Audit Procedures

1. Inspection of Records and documents 2. Inquiry of knowledgeable persons within or outside entity. 3. External Confirmation (sending letter to bank confirming invoice) 4. Inspection of tangible assets 5. Observation of processes or procedures being performed by others. 6. Recalculation of mathematical accuracy 7. RePerformance of procedures (someone else enters in information to computer) 8. Analytical Procedures (looking for something out of ordinary )

What are the objectives of the client's representation letter?

1. Remind the clients officers of their primary responsibility for the financial statements. 2. Provide evidence that management believes that adjusting entries brought to its attention by the auditors and not made are not material. 3. Provide written documentation of the clients replies to various inquiries made by the auditors during the examination. 4. Provide evidence in those areas in which accounting presentations are dependent upon management future intentions.

List and describe four techniques that may be used by the auditors in developing expectations for analytical procedures.

1. Trend Analysis: Involves the review of changes in an account balance over time. 2. Ratio analysis: involves comparison of relationships between two or more financial statement accounts, or comparisons of account balances to non financial data. The two basic approaches are horizontal analysis and cross sectional analysis. 3. Regression analysis: Involves the use of statistical models to quantify the auditors expectations about financial statement amount or ratio. 4. Reasonableness Test: Similar to regression in that an exception is developed, but use other approaches to develop the estimate.

Business Characteristics Indicative of High Inherent Risk

1.Inconsistnet profitability of the client relative to other firms in industry 2. Operating results that are highly sensitive to economic factors 3. Going concern problems: likely hood of company staying in business/ bankruptcy 4. Large known and likely misstatements detected in prior audits 5. Substantial turnover, questionable reputation, or inadequate accounting skills of management

how long must audit documentation be retained

7 years

Which of the following is not an assertion relating to classes of transactions?

A. Accuracy *B. Sufficiency* C. Cutoff D. Classification

Which of the following is not a financial statement assertion relating to account balances?

A. Completness B. Existence C. Rights and obligations *D. Valuation and allowances*

Measuring Audit Risk (Equation)

AR=IRxCRxDR

Audit Risk

After all audit tests are done, some will still pass by. But very few.

Audit Evidence SAS 326

All the information used by the auditor in arriving at the conclusions on which the audit opinion is based and includes the information contained in the accounting records underlying the financial statements and other information. Includes evidence obtained from audit procedures performed during the course of the audit and may include audit evidence obtained from other sources, such as previous audits and a firms quality control procedures.

Audit Evidence

All the information used by the auditor in arriving at the conclusions on which the audit opinion is based and includes the information contained in the accounting records. -In performing financial statement audits, what the auditor gathers and evaluates to form an opinion.

Explain how analytical procedures are useful in: Near the end of the audit.

Analytical procedures applied at the overall review stage of an audit provide an overview of the final audit figures. This final application is to provides assurance that the end results of the audit "make sense", and that the auditors have not "failed to see the forest for the trees"

Explain how analytical procedures are useful in: The substantive procedures stage of the audit.

Analytical procedures performed as substantive procedures are useful because they provide the auditors with evidence that substantiates the reasonableness of specific account balances or financial statement amounts.

Which of the following is not basic approach often used by auditors to evaluate the reasonableness of accounting estimates?

Confirmation of amounts

During financial statement audits, auditors seek to restrict which type of risk?

Detection Risk

Which (if any) of these components is completely a function of the sufficiency of the evidence gathered by the auditors' procedures? Explain your answer.

Detection risk: risk that the auditors fail to detect a misstatement- is the only risk that is completely a function of the sufficiency of the evidence gathered by the auditor's procedures. It only exists when an audit (or other attest service) is being performed. Inherent risk and control risk are a function of the client and its operating environment. Regardless of how much evidence the auditor gathers, they cannot change the actual levels of these risks. Evidence gathered by the auditors is used to asses the levels of inherent and control risk. On the other hand, evidence gathered for detection risk is used to restrict audit risk to the appropriate level.

What type of transaction ordinarily has high inherent risk because they involve management judgements or assumptions in formulating accounting balances?

Estimation

Control Risk

Has internal control, misstatements prevented by controls

Explain how analytical procedures are useful in: The risk assessment stage of the audit.

Helps the auditors in obtaining an understanding of the clients business and may direct the auditor's attention to potential problems and to areas requiring special investigation.

Who reviews or may review audit documentation

Members of engagement team performing the work. -Auditors new to engagement and review priors years to understand. -Supervisory personnel -Engagement supervisors and engagement quality reviewers -Successor auditor -Internal and external inspection teams -Advisor engaged by audit committees or rep of party.

Inherent Risk

No internal control

Define audit risk.

Possibility that the auditors may unknowingly fail to appropriately modify their opinion on financial statements that are materially misstated. It consists of the possibility that 1. a material misstatement in an assertion about an account has occurred (inherent risk and control risk) and 2. the auditors do not detect the misstatement (detection risk)

Who should prepare and sign the client's representation letter?

Prepared on client's letterhead and signed by appropriate officer and employees. CPAS will draft the representation letter, but officers or employees must accept the statement in the letter as their own representation. Signed by one or more officers or responsible employees who are knowledgable the the particular area or activity reported upon. Usually signed by client's chief executive officer ad chief financial officer at minimum.

Computational Working Papers

Recalculate allowance for doubtful accounts

Describe its components of inherent risk, control risk, and detection risk.

Refers to the possibility of a material misstatement occurring before considering internal control. Control risk is the risk that a material misstatement will not be prevented or detected on a timely basis by the company's internal control. Detection risk is the risk that the auditors will fail to detect the misstatement with their audit procedures.

Which of the following is basic approach often used by auditors to evaluate the reasonableness of accounting estimates

Reviewing subsequent events or transactions

Detection Risk

Risk that auditors will fail to detect material misstatement.

Explain the interrelationship among these components.

Risks vary inversely from one another. The less inherent or control risk the auditor believes exists, the greater the acceptable detection risk. Conversely, the greater the inherent or control risk the auditor believes to lists, the less the acceptable detection risk.

Assertions with high inherent risk are lease likely to involve

Routine transactions

When should the client's representation letter be obtained?

Since it refers to events occurring in the subsequent period, it is appropriate that the letter be signed, dated, and delivered to the auditors on the last day of fieldwork.

Distinguish between sufficiency and appropriateness of audit evidence.

Sufficiency: measure of the quantity of audit evidence. Appropriateness: Measure of the quality of audit evidence, relevance and reliability in providing support for or detecting misstatements in the FS.

Which of the following is generally true about the sufficiency of audit evidence?

The amount of evidence that is sufficient varies inversely with the risk of material misstatement.

What is the 3rd standard of fieldwork?

The auditor must obtain sufficient appropriate audit evidence by performing audit procedures to adored a reasonable basis for an opinion regarding the financial statements under audit.

Relationship between the risk of misstatement and the amount of evidence required

The greater the risk, the more audit evidence is to be required

Comment on the following: "Since cash is often less than 1 percent of total assets, inherent and control risk for that account must be low. Accordingly, detection risk should be established at a high level."

The statement is incorrect in that it overlooks the liquid nature of cash as well as its high rate of turnover. Throughout a year a large amount of cash is typically generated and spent, allowing for material misstatements, potential embezzlement, and other improper use. Thus, inherent risk for the account is normally high. Control risk is based on the operating effectiveness of a company's internal control. Because inherent risk is high and control risk varies from client to client, little can be said concerning the appropriate level of detection risk.

Explain audit documentation

Written record of the basis for the auditors conclusions that provides the support for the auditors representations. Also facilities the planning, performance, and supervision of the engagement, and is the basis for the review of the quality of work. Includes records of planning and performance of work, procedures performed, evidence obtained, and conclusions reached by auditor.

Auditor required to document every conversation with client management and or engagement team members

when inquiry is important to particular procedure. not each conversation that occurs.