Chapter 4 Review Questions/Problems
4.1 Define audit risk.
Audit risk is the probability that an audit team will express an inappropriate audit opinion when the financial statements are materially misstated (i.e., give an unmodified opinion on financial statements that are misleading because of material misstatements that the auditors failed to discover).
4.3 How is the audit risk model used to plan the audit?
They set the desired level of audit risk, assess the inherent and control risk to solve for detection risk. Detection risk is then used to plan the audit, and sets how much testing to do on the audit.
4.14 What is the purpose of performing preliminary analytical procedures in audit planning?
to identify potential problem areas so that subsequent audit work can be designed to reduce the risk of missing something important. Analytical procedures during the preliminary stages also provide an organized approach—a standard starting place—for becoming familiar with the client's business. Auditors need to remember that preliminary analytical procedures are based on unaudited data, so they should consider the effectiveness of controls over their reliability when deciding how much weight to place on the results
4.18 How do the professional audit standards differ for (a) errors, (b) frauds, (c) direct-effect noncompliance, and (d) indirect-effect noncompliance?
Auditing standards deal with two types of noncompliance: (1) direct-effect noncompliance, which produces direct and material effects on financial statement amounts (e.g., violations of pension laws or overnment contract regulations for revenue and expense recognition) that require the same assurance as errors and frauds (i.e., auditors must plan their work to provide reasonable assurance there are no material misstatements) (2) indirect-effect noncompliance, which refers to violations of laws and regulations that are not directly connected to financial statements (e.g., occupational health and safety, food and drug administration regulations, environmental protection, and equal employment pportunity). The difference from fraud and errors: Auditor responsibility for detecting indirect-effect noncompliance is limited as follows. If the auditor becomes aware of the possibility that an illegal act occurred that might have a material effect on the financial statements, the auditor should perform procedures that are directly focused on whether such an illegal act occurred. Otherwise, because the auditor cannot be considered an expert in all laws and regulations, an auditor is not required to provide assurance about indirect-effect noncompliance. If the auditor thinks illegal act may have occurred, the auditors must inform the organization's board of directors. When the auditors believe the illegal act has a material effect on the financial statements, the board of directors has one business day to inform the U.S. Securities and Exchange Commission (SEC). If the board decides not to inform the SEC, the auditors must (1) within one business day give the SEC the same report they gave the board of directors or (2) resign from the engagement and, within one business day, give the SEC the report. If the auditors do not fulfill this legal obligation, the SEC can impose a civil penalty (e.g., monetary fine) on them
4.12 What is the major concern for auditors related to evidence obtained from related parties?
Because one of the basic assumptions of historical cost accounting is that transactions are valued at prices agreed on by two independent parties (i.e., "arm's-length transactions"), valuation of related-party transactions is particularly troublesome so basically, it may be biased and need more testing to avoid fraud
4.2 What are the components of the risk of material misstatement (RMM)? What are the components of the audit risk model?
Inherent risk is the probability that, in the absence of internal controls, material errors or frauds could enter the accounting system used to develop financial statements Control risk is the probability that the client's internal control activities will fail to prevent or detect material misstatements provided that such misstatements enter or would have entered the accounting system in the first place. Detection risk is the probability that the auditor's own procedures will fail to detect material misstatements provided that any have entered the accounting system in the first place and have not been prevented or detected and corrected by the client's internal controls RMM = IR x CR AR = RMM x DR The audit risk model assumes that each of the elements is independent.
4.17 When are analytical procedures required, and when are they optional?
Professional standards mandate that analytical procedures are performed at the beginning of an audit—the preliminary stage application of analytical procedures discussed in this chapter and at the end of an audit when the partners in charge review the overall quality of the work and look for apparent problems. Analytical procedures can also be used as a substantive testing procedure to gather evidence about the relevant assertion being tested. When using substantive analytical procedures, the auditor must take great care to develop an independent expectation that is based on reliable information.
4.4 What is meant by the terms nature, timing, and extent of further audit procedures?
The nature of an audit procedure refers to the type of procedure (e.g., observation, recalculation, inquiry) and the purpose of the procedure (e.g., test of controls, substantive procedure). When determining the nature of the audit procedure, the auditor is considering what to do. Timing refers to when the audit procedures will be completed. To do so, the auditor typically considers whether to complete the procedures at an interim date or at the balance sheet date. While confirmation of accounts receivable may be performed at an interim date, auditors are expressing an opinion on year-end balances. The closer the procedures are performed to year-end (the balance sheet date), the more effective they are because there is less chance of a material misstatement occurring between the interim confirmation date and year-end. eEtent refers to the number of tests performed. Clearly, the larger the number of accounts receivable confirmations that are mailed to customers, the greater the chance of finding errors and fraud, and therefore, the lower the detection risk.
4.49 Analytical Procedures and Interest Expense. Weyman Z. Wannamaker is the chief financial officer of Cogburn Company. He prides himself on being able to manage the company's cash resources to minimize the interest expense. Consequently, on the second business day of each month, Weyman pays down or draws cash on Cogburn's revolving line of credit at First National Bank in accordance with his cash requirements forecast. You are the auditor. You find the information on this line of credit in the following table. You inquired at First National Bank and learned that Cogburn Company's loan agreement specifies payment on the first day of each month for the interest due on the previous month's outstanding balance at the rate of "prime plus 1.5 percent." The bank gave you a report that showed the prime rate of interest was 8.5 percent for the first six months of the year and 8.0 percent for the last six months. Cogburn Company Notes Payable Balances Date Balance Jan 1 $150,000 Feb 1 200,000 Apr 1 225,000 May 1 285,000 Jun 1 375,000 Aug 1 430,000 Sep 1 290,000 Oct 1 210,000 Nov 1 172,000 Dec 1 95,000 Required: a. Prepare an audit estimate of the amount of interest expense you expect to find as the balance of the interest expense account related to these notes payable. b. Which of the types of analytical procedures did you use to determine this estimate? c. Suppose that you find that the interest expense account shows expense of $23,650 related to these notes. What could account for this difference? d. Suppose that you find that the interest expense account shows expense of $24,400 related to these notes. What could account for this difference? e. Suppose that you find that the interest expense account shows expense of $25,200 related to these notes. What could account for this difference?
a) b) recalculation c) d) e) missing payments? or miscalcuation
4.51 Risk of Misstatement in Various Accounts. An auditor must identify the relevant assertions about each significant financial statement account and disclosure and then gather evidence to conclude whether a material misstatement exists for each assertion. The nature of each financial statement account and disclosure contributes to the likelihood that a material misstatement exists. a. In general, which accounts are most susceptible to overstatement? To understatement? b. Why do you think a company could permit asset accounts to be understated? c. Why do you think a company could permit liability accounts to be overstated? d. Which direction of misstatement is most likely: income overstatement or income understatement?
a) Understatements of inventory may occur due to pricing and counting errs. Understatements of the fixed assets may result due to failure to capitalize costs (instead of expensing them) or due to inaccurate calculations of depreciation. Understatement of liability and expense seem to be reasonably common b) understatements of asset can be resulted from measurement errors, inaccurate implementation of accounting principles, and accounting errors. c) Projected liabilities might be higher than conversation. There might be over accruing expenses by the company. d) Overstatement of income exists most repeatedly; the cause is often expenses understatement (like accrued expenses), or revenue overstatement (inappropriate revenue recognition policy choice or interpretation).
4.58 Auditing an Accounting Estimate. Suppose management estimated the market valuation of some obsolete inventory at $99,000; this inventory was recorded at $120,000, which resulted in recognizing a loss of $21,000. The auditors obtained the following information: The inventory in question could be sold for an amount between $78,000 and $92,000. The costs of advertising and shipping could range from $5,000 to $7,000. Required: a. Would you propose an audit adjustment to the anagement estimate? Prepare the appropriate accounting entry. b. If management's estimate of inventory market (lower than cost) had been $80,000, would you propose an audit adjustment? Prepare the appropriate accounting entry.
a) Yes, an audit modification has to be proposed in this management estimate to solve the anomaly. The loss of $21,000 ($120,000 - $99,000) can be posted in the books of accounts of the company under the Receipts and Payments account. The additional costs of the shipping and advertising costs would not be taken into consideration as the review adjustment would include only the posting of the amount of loss incurred in this case for the deduction in the value of the outdated inventory. b) If the inventory market was recorded at an amount of $80,000, then there would be a profit of $19,000 ($99,000 - $80,000) and that would be posted as a receipt of the appreciation of the stock. An audit alteration would not be required in this case