Chap03 Study Guide

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Chapter 3

Risk Assessment andMateriality

KEY THOUGHT

The auditor has a responsibility to plan and perform the audit to obtain

reasonable assurance about whether the financial statements are free of

material misstatement, whether caused by error or fraud. Because of thenature of audit evidence and the characteristics of fraud, the auditor is able

to obtain reasonable, but not absolute, assurance that materialmisstatements are detected Auditin! "tandards Board #A$ %%&.&'().

CHAPTER SUMMARY

[LO1] Understand the concept of ad!t r!s"#

A. Risk is the first concept that underlies the audit process. An auditor en!a!ed to perform a

financial statement audit faces two types of risk* audit risk and en!a!ement risk. Audit

risk is the risk that the auditor may unknowin!ly fail to appropriately modify the opinion

on financial statements that are materially misstated. +n!a!ement risk is the auditorse-posure to loss or inury to professional practice from liti!ation, adverse publicity, or

other events arisin! in connection with financial statements audited and reported on.

B. The auditor should perform the audit to reduce audit risk to a level appropriate for

e-pressin! an opinion on the financial statements. /n doin! so, the auditor needs to

consider audit risk at the financial statement level #pervasively( and at the account

balance or class of transactions level.

C. /n considerin! audit risk at the overall financial statement level, the auditor considers

risks of material misstatement that relate pervasively to the financial statements and

potentially affect many assertions. "uch risks often relate to the entitys control

environment and may be relevant to the auditors consideration of the risks of materialmisstatement arisin! from fraud #mana!ement override of internal control(.

0. The auditor also considers audit risk at the individual account balance or class of

transactions level because such consideration directly assists the auditor to plan the

appropriate audit procedures.

+. 1ike audit risk, the auditor must consider en!a!ement risk. +n!a!ement risk relates to an

auditors e-posure to financial loss and dama!e to his or her professional reputation. 2or

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e-ample, an auditor may conduct an audit in accordance with 4AA" #or 5CA6B

auditin! standards for public companies( and still be sued by the client or a third party.

+ven if the auditors wins the lawsuit, his or her professional reputation may be dama!ed

in the process by the ne!ative publicity.

2. 7hile en!a!ement risk cannot be directly controlled by the auditor, some control can be

e-ercised throu!h the careful acceptance and continuance of clients. Audit risk, on theother hand, can be directly controlled by the scope #nature, timin! and e-tent of audit

procedures( of the auditors work.

[LO$] Learn the for% and co%ponents of the ad!t r!s" %ode

A. Auditin! standards do not provide specific !uidance on what is an acceptable level of

audit risk, but auditors use the audit risk model as a framework for assessin! risks.

B. The determination of audit risk and the use of the audit risk model involve professional

ud!ment on the part of the auditor. Auditors use the audit risk model to determine the

scope of auditin! procedures for a particular account balance or class of transactions

level. The model can be specified as*

AR ' (R x CR x )R

where

AR 8 Audit risk #the risk that the auditor may fail to modify the

opinion on materially misstated financial statements(

/R 8 /nherent risk #the susceptibility of an assertion to material

misstatements, assumin! no related controls(

CR 8 Control risk #the risk that material misstatements that couldoccur in an assertion will not be prevented or detected on a

timely basis by the internal controls(

0R 8 0etection risk #the risk that the auditor will not detect a material

misstatement that e-ists in an assertion(

9ote that detection risk can be divided further into analytical procedures risk and

substantive tests of details risk. Analytical procedures risk is the risk that substantive

analytical procedures and other relevant substantive tests will fail to detect material

misstatements, while tests of details risk is the allowable risk for failin! to detect a

material misstatement that is not detected by internal controls or analytical procedures

and other relevant substantive tests. /n discussion of the audit risk model, detection riskwill not be divided for ease of presentation.

C. 0etection risk results from two uncertainties that are a function of the effectiveness of an

audit procedure and of its application by the auditor. The first uncertainty is called

samplin! risk. Because the auditor e-amines only a subset of the population, the sample

may not represent the population, and the auditor may draw the wron! conclusion on the

fairness of the account balance. The second uncertainty is called nonsamplin! risk and

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can occur because the auditor used an inappropriate audit procedure, failed to detect a

misstatement when applyin! an appropriate audit procedures, or misinterpreted the audit

results. 9onsamplin! risk can be reduced to a ne!li!ible level throu!h ade;uate plannin!,

proper assi!nment of audit staff, supervision and review of the audit work performed, and

supervision and conduct of a firms audit practice in accordance with appropriate ;ualitycontrol standards.

0. At the account balance or class of transaction level, audit risk consists of*

%. The risk that the balance or class and related assertions contain misstatements

that could be material to the financial statements when a!!re!ated with

misstatements in other balances or classes #inherent risk and control risk(.

'. The risk that the auditor will not detect such misstatements #detection risk(.

+. /nherent risk and control risk differ from detection risk. /nherent risk and control risk are

functions of the entity and its environment, so the auditor has little or no control over

these risks. "ometimes the combination of these two risks is referred to as auditee risk.

2. 0etection risk can be controlled by the auditor throu!h the scope of the audit procedures

performed. 0etection risk has an inverse relationship to inherent risk and control risk. 2or

e-ample, if inherent risk and control risk are ud!ed to be hi!h, the auditor sets a lower

level of detection risk in order to meet the planned level of audit risk.

4. The auditors assessment of audit risk and its component risks #/R, CR and 0R( is a

matter of professional ud!ment. At the completion of the audit, the actual level of audit

risk is not known with certainty by the auditor. /f the auditor assesses the achieved audit

risk as bein! less than or e;ual to the planned level of audit risk, an un;ualified report can

be issued. /f the assessment of the achieved level of audit risk is !reater than the planned

level, the auditor should either conduct additional audit work or ;ualify the audit report.

[LO*] Understand ho+ to se the ad!t r!s" %ode

A. The audit risk model e-presses the !eneral relationship of audit risk and the components

of the model. The model is not intended to be a mathematical formula includin! all

factors that may influence the assessment of audit risk, but auditors find the model useful

when plannin! appropriate risk levels for audit procedures to reduce the desired audit risk to an appropriate level #2i!ure 3


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)R '

AR

(R x CR

The auditor uses this level of detection risk to desi!n the audit procedures that will reduce

audit risk to an acceptable level. >owever, the auditor should not rely completely on his

or her assessments of inherent risk and control risk to the e-clusion of performin!

substantive tests of account balances, where material misstatement could e-ist. Consider

the e-ample of the computation of detection risk that was provided in your te-tbook*

"uppose that the auditor has determined that the planned audit risk for the accounts

receivable balance can be set at &.&? based on the si!nificance of the account to the

financial statements. By establishin! such a low level of audit risk, the auditor is reducin!

the possibility that the account may contain a material misstatement. Assume further that

the auditor assesses inherent risk for accounts receivable to be &.:&. After evaluatin! the

internal control over the revenue process, the auditor assesses control risk to be &.@&.

"ubstitutin! the values for AR, /R and CR into the e;uation indicates that the auditor

should set detection risk at appro-imately &.%& 0R 8 &.&?#&.:& x &.@&() for testin! the

accounts receivable balance. Thus, the auditor establishes the scope of the audit for

accounts receivable so that there is only a %& percent chance that a material misstatement,

if present, is not detected.

An auditor may find it more appropriate to substitute ;ualitative terms to utilie the risk

model. 2or e-ample, audit risk mi!ht be classified into three cate!ories, very low, low

and moderate. /t is unlikely that an audit planned in accordance with 4AA" #or 5CA6B

standards for public company audits( would consider a hi!h level of audit risk. The

remainin! component of the model may be classified into cate!ories such as low,

moderate or hi!h. This method of usin! the model is identical to that followed whenusin! numerical values. Audit risk would be set usin! one of the cate!ory choices.

"imilarly, the auditor would assess the appropriate cate!ory for inherent and control risk.

[LO,] Understand the ad!tor-s r!s" assess%ent process#

A. "trate!ies are operational approaches used to achieve obectives. Business risks are

threats to mana!ements ability to e-ecute its strate!ies and to achieve its obectives.

Business activities, strate!ies, obectives and the business environment are ever chan!in!

and the dynamic and comple- nature of business cause business risks. Mana!ement is

responsible for identifyin! these risks and respondin! to them.

B. Business risk is broader than the risk of materially misstated financial statements, but

most business risks have the potential to affect the financial statements eitherimmediately or in the lon! run. Auditors need to identify business risks and understand

the potential misstatements that may result.

C. The audit process starts by obtainin! and supportin! an understandin! of the entity and

its environment, includin! internal control. 6btainin! an understandin! of the entity andits environment is a continuous, dynamic process of !atherin!, updatin! and analyin!

information throu!hout the audit. The !oal of this step is to assess the business risks

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faced by the entity. Based on the auditors understandin! of the entitys business risks and

how those risks are controlled or not controlled, the auditor assess the risk of material

misstatement at the assertion level. The auditors assessment of business risk and the risk

of material misstatement #i.e., the auditors risk assessment process( includes the

followin! steps #2i!ure 3


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. 0iscussions with mana!ement.

:. Minutes of board of directors andor audit committee meetin!s.

=. +ntitys business andor strate!ic plans, bud!ets or other documentation.

%&. Reports prepared by analysts, banks, underwriters, ratin! a!encies, etc.

%%. /ndividuals knowled!eable about the industry, such as the en!a!ement team

members for clients in a similar business or industry.

%'. Audit firm

applicable.

%3. 4overnment statistics.

%. +conomic and financial ournals.

%?. /ndustry or trade ournals.

%@. Client press releases, publications, and brochures.

%. /nternal audit reports.

9ote that information obtained or derived from sources e-ternal to the entity !enerally

can be deemed reliable in the absence of evidence to the contrary. /nformation obtained

from sources within the entity may re;uire a more ini!h de!ree of comple- re!ulation.

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The auditor should evaluate mana!ements response to identified risks. /f the response is

ade;uate, the risk of material misstatement may be reduced, but if the response to the risk

is inade;uate, the auditor may increase the risk of material misstatement.

[LO.] (dent!f/ the factors that deter%!ne the ad!tor-s assess%ent of the r!s" of %ater!a&

%!sstate%ent#

A. To assess the risk of material misstatement, the auditor*

%. /dentify risks by considerin! the entity and its environment, includin! controls

that relate to the risks, and by considerin! the classes of transactions and account

balances in the financial statements.

'. Relates the identified risks to what can !o wron! at the assertion level.

3. Considers whether the risks are of a ma!nitude that could result in a material

misstatement of the financial statements.

. Considers the likelihood that the risks will result in a material misstatement ofthe financial statements.

The auditor must determine whether the identified risks of material misstatement relate to

specific classes of transactions or account balances and related assertions, or whetherthey relate more pervasively to the financial statements as a whole and potentially affect

many assertions.

B. A misstatement of the financial statements may consist of any of the followin!*

%. The difference between the amount, classification or presentation of a reported

financial statement element, account, or item and the amount, classification or

presentation that would have been reported under 4AA5.

'. The omission of a financial statement element, account or item.

3. A financial statement disclosure that is not presented in accordance with 4AA5.

. The omission of information re;uired to be disclosed in accordance with 4AA5.

C. Misstatements can result from error or fraud. The primary distinction between errors and

fraud is whether the misstatement was intentional or unintentional. >owever, it is often

difficult to determine intent.

0. +rrors are unintentional misstatements or omissions of amounts or disclosures and mayinvolve*

%. Mistakes in !atherin! or processin! data from which statements are prepared.

'. $nreasonable accountin! estimates arisin! from oversi!ht or misinterpretation of

facts.

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3. Mistakes in the application of accountin! principles relatin! to amount,

classification, manner of presentation, or disclosure.

+. 2raud, from the auditors perspective involves intentional misstatements that can be

classified into two types* #%( misstatements arisin! from fraudulent financial reportin!and #'( misstatements arisin! from misappropriation of assets. 2raudulent financial

reportin! may involve acts such as*

%. Manipulation, falsification or alteration of accountin! records or supportin!

documents from which financial statements are prepared.

'. Misrepresentation in, or intentional omission from, the financial statements of

events, transactions, or other si!nificant information.

3. /ntentional misapplication of accountin! principles relatin! to amounts,

classification, manner of presentation, or disclosure.

Misstatements arisin! from misappropriation of assets #sometimes referred to as

defalcation( involve the theft of an entitys assets where the defalcation causes thefinancial statements to be misstated. +-amples of misappropriation include*

%. +mbelin! cash received.

'. "tealin! assets.3. Causin! the entity to pay for !oods or services not received.

9ote that misappropriation of assets may be accompanied by false or misleadin! records

or documents, possibly created by circumventin! controls, and may involve one or more

individuals amon! mana!ement, employees, or third parties.

2. Three conditions are !enerally present when material misstatements due to fraud occur

#incentives and pressures, opportunities and attitudes and rationaliation(*

%. Mana!ement or other employees have an incentive or are under pressure that

provides a reason to commit fraud.

'. Circumstances e-ist that provide opportunity for fraud to be carried out.

3. Those involved are able to rationalie committin! a fraudulent act. "ome

individuals possess an attitude, character, or other set of ethical values that allow

them to knowin!ly and intentionally commit a dishonest act. +ven honest

individuals can commit fraud in an environment where sufficient pressure is bein! e-erted on them. The !reater the incentive or pressure, the more likely an

individual will be able to rationalie the acceptability of committin! fraud.

4. Mana!ement has the ability to perpetrate fraud because it is in a position to directly or

indirectly manipulate the accountin! records and prepare fraudulent financial reports. /n

most cases, fraudulent financial reportin! also involves some mana!ement override of

controls. Because of the characteristics of fraud, particularly those involvin! concealment

throu!h collusion #withheld, misrepresented or falsified documentation( and the ability of

mana!ement to override or instruct others to override controls, an auditor may

unknowin!ly rely on fraudulent audit evidence.


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>. The fraud risk identification process includes #2i!ure 3


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2or low


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/f the results of the audit test indicate a si!nificant risk of fraud, the auditor should

consider withdrawin! from the en!a!ement and communicatin! the reasons for

withdrawal to the audit committee or others with e;uivalent authority and responsibility.

[LO3] Understand the doc%entat!on re4!re%ents for r!s" assess%ents and responses#

A. The auditor has e-tensive documentation re;uirements for understandin! the entity andits environment, the consideration of fraud, and respondin! to assessed risks. The auditor

should document the risk of material misstatement for all material accounts and classes of

transactions in terms of the related assertions. The level of risk may be described

;uantitatively or non;uantitatively #hi!h, medium or low(. +-hibit 3


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the auditors ethical or le!al obli!ations of confidentiality. The auditor should reco!nie

that in the followin! circumstances a duty to disclose outside the entity may e-ist*

%. To comply with certain le!al and re!ulatory re;uirements.

'. To a successor auditor when the successor makes in;uires in accordance with A$

3%? #Communications between 5redecessor and "uccessor Auditors(.

3. /n response to a subpoena.

. To a fundin! a!ency or other specified a!ency in accordance with re;uirements

for the audits of entities that receive !overnmental financial assistance.

[LO17] Learn the &!%!tat!ons of the ad!t r!s" %ode

A. Auditin! standards provide for the use of the audit risk model as a way of ensurin! that

the risk of issuin! materially misstated financial statements is kept to an acceptably low

level. >owever, this model has a number of limitations that must be considered by

auditors and their firms.

B. The audit risk model is a plannin! tool. /f an auditor uses the model to revise an audit

plan or to evaluate audit results, the actual level of audit risk may be !reater than the

audit risk indicated by the formula. This may occur because the model assumes that thecomponents #/R, CR and 0R( are independent of one another as indicated by the

multiplicative form of the model. >owever, in practice, the risk of a material

misstatement #/R( occurrin! may be a function of the clients internal controls #CR(.

Thus, inherent risk may depend on control risk. /n practice, some public accountin! firms

make a combined risk assessment for /R and CR #auditee risk(.

C. 6ther limitations may also be present. 2or e-ample, because the auditor assesses inherent

risk and control risk, such assessments may be hi!her or lower than the actual inherentrisk and control risk that e-ist for the client. "uch differences can affect the determination

of detection risk and the achieved audit risk. The audit risk model also does not

specifically consider the possibility of auditor error.

[LO11] Understand the concept of %ater!a&!t/#

A. The auditors consideration of materiality on an audit is a matter of professional

ud!ment. Materiality is assessed in terms of the potential effect of a misstatement on

decisions made by a reasonable user of the financial statements. This focus arises from

the 2A"Bs "tatement of 2inancial Accountin! Concepts 9o. ', which states*

Mater!a&!t/ is the ma!nitude of an omission or misstatement of accountin!information that, in the li!ht of surroundin! circumstances, makes it probable

that the ud!ment of a reasonable person relyin! on the information would

have been chan!ed or influenced by the omission or misstatement.

B. 5rofessional standards do not provide specific !uidance on how to assess what is material

to a reasonable user. The A/C5A and auditin! firms have developed policies and

procedures to assist auditors in establishin! materiality. 9ote that the auditor will

consider both ;uantitative and ;ualitative aspects of the en!a!ement.

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[LO1$] (dent!f/ the steps to app&/!n6 %ater!a&!t/ !n an ad!t#

A. 7hile the policies and procedures of individual auditin! firms may differ in some

respects, a three


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avera!e of the previous years income or another base if the current year preta- income is

not stable, predictable or representative of an entitys sie.

+-hibit 3


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fraction of the account #often less than ' percent(. By usin! a tolerable

misstatement percenta!e that is considerably less than materiality, the scope of

planned auditor procedures will be sufficiently precise to identify si!nificant

misstatements.

. 7hen control weaknesses or misstatements are identified, the auditors typically

perform additional procedures. The actual testin! will often achieve a muchsmaller mar!in for misstatement than planned tolerable misstatement.

?. 6verall financial statement materiality serves as a Fsafety net.G /f individual

unadusted misstatements are less than tolerable misstatement, but a!!re!ate to

an amount !reater than materiality, the auditor cannot accept the financial

statements as presented fairly in accordance with 4AA5. 7hen this occurs, the

client would need to #%( make adustments to lower the unadusted misstatements

below materiality, #'( the auditor would need to perform more testin!, andor

#3( the auditor would issue a ;ualified or adverse opinion.

Taken to!ether, these points su!!est that it would be inefficient for the auditor to simply

subdivide materiality proportionally to each account because this would result inunnecessarily low tolerable misstatement levels. The lower the tolerable misstatement is,

the more e-tensive the re;uired audit testin!. /n the e-treme, if tolerable misstatement

were very small or ero, the auditor would have to test every transaction in an account.

Step * Est!%ate &!"e&/ %!sstate%ents and co%pare tota&s to the pre&!%!nar/

9d6%ent a8ot %ater!a&!t/# The third step is completed near the end of the audit, when

the auditor evaluates all the evidence that has been !athered. Based on the results of the

audit procedures conducted, the auditor a!!re!ates misstatements from each account or

class of transactions. The a!!re!ate amount includes known misstatements and

proections based on the sample data collected. /t should also include consideration of the

effect of misstatements not adusted in the prior period because they were ud!ed to be

immaterial. The auditor compares this a!!re!ate misstatement #referred to as likelymisstatement( to the preliminary ud!ment about materiality. /f the auditors ud!ment

about materiality at the plannin! sta!e #"tep %( was based on the same information

available at the evaluation sta!e #"tep 3(, materiality for plannin! and evaluation would

be the same. >owever, the auditor may identify factors or items durin! the course of the

audit that cause a revision to the preliminary ud!ment about materiality. Thus, the

preliminary ud!ment about materiality may differ from the materiality ud!ment used inevaluatin! the audit findin!s. 7hen this occurs, the auditor should carefully document

the reasons for revisin! the preliminary ud!ment about materiality.

As discussed in "tep %, a number of ;ualitative factors that can potentially affectmateriality. 7hen evaluatin! the materiality of unadusted misstatements, the auditor

should consider the followin! ;ualitative factors #Table 3


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. 7hether the misstatement concerns a se!ment or other portion of the business

that has been portrayed as playin! a si!nificant role in the operations or

profitability of the entity.

?. 7hether the misstatement affects compliance with re!ulatory re;uirements.

@. 7hether the misstatement affects compliance with loan covenants or othercontractual re;uirements.

. 7hether the misstatement increases mana!ements compensation.

:. 7hether the misstatement involves the concealment of an unlawful transaction.

=. 7hether the misstatement may result in a si!nificant positive or ne!ative market

reaction.

%&. 7hether small intentional misstatements are part of actions to Fmana!eG

earnin!s.

7hen the likely misstatements are less than the preliminary ud!ment about materiality,

the auditor can conclude that the financial statements are fairly presented. Conversely,

when the likely misstatements are !reater than the planned ud!ment about materiality,

the auditor should re;uest that the client adust the financial statements. /f the clientrefuses to adust the financial statements for the likely misstatements, the auditor should

issue a ;ualified or adverse opinion because the financial statements do not present fairly

in conformity with 4AA5.

[LO1*] App&/ the %ater!a&!t/ steps to an e:a%p&e ;Earth


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CHAPTER *> SEL?@ASSESSMET

Part (> Tre or ?a&se Best!ons

16%) HHHH %. Audit risk is the auditors e-posure to loss or inury of his or her reputation

from events arisin! in connection with financial statements audited.

16%) HHHH '. +n!a!ement risk is the auditors e-posure to loss or inury of his or her

reputation from events arisin! in connection with financial statements audited.

16') HHHH 3. The components of the audit risk model include inherent risk, control risk and

detection risk.

16') HHHH . /nherent risk is the susceptibility of an assertion to material misstatement,

assumin! no related controls.

16') HHHH ?. 5rofessional ud!ment must be used when evaluatin! business risk.

16') HHHH @. Audit risk and materiality si!nificantly impact the auditors evidence decisions.

16') HHHH . The risk of a material misstatement includes inherent risk and samplin! risk.

16') HHHH :. The combination of inherent risk and control risk is referred to as auditee risk.

16') HHHH =. /nherent risk includes samplin! risk and nonsamplin! risk.

16%%) HHHH %&. Materiality is the value of an omission in the financial statements that must be

adusted.

Part ((> M&t!p&e Cho!ce Best!ons

16') %. /f internal control over sales and cash receipts is e-cellent, detection risk would be*

a. 0ecreased.

b. $naffected.

c. /ncreased.

d. Cannot be determined from the information provided.

16') '. The audit risk model includes all but the followin! components*

a. 0etection risk.

b. +n!a!ement risk.

c. /nherent risk.

d. Control risk.

16') 3. /nherent risk and control risk are*

a. 2unctions of the en!a!ement risk.

b. 2unctions of uncertainty.

c. 2unctions of the entity and its environment.

d. 2unctions of samplin! and nonsamplin! risks.

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16') . The audit risk model is used at the account balance or class of transaction level to*

a. Assess inherent risk and control risk so that detection risk can be determined.

b. +stablish the preliminary ud!ment about materiality #tolerable misstatement(.

c. "et a planned level of audit risk.

d. Both a and c.

163) ?. 5lanned audit risk for inventory has been set at &.&?. /nherent risk has been set at &.&and control risk was assessed to be &.@&. The detection risk will be set at #rounded(*

a. &.%?.

b. &.%.

c. &.%'.

d. Cannot be computed based on the information provided.

16) @. The auditor obtains an understandin! of the entity and its environment by performin!

all of the followin! assessment procedures e-cept*

a. /n;uires of mana!ement and others.

b. Compute the level of detection risk.

c. Analytical procedures.

d. 6bservation and inspections.

16?) . An e-ample of an error is*

a. "tealin! inventory.

b. An intentional omission of a si!nificant transactions. c. A mistake in the application of an accountin! principle.

d. +mbelin! cash receipts.

16?) :. Certain conditions are !enerally present when fraud occurs, includin!*

a. /ncentives and pressures.

b. 6pportunities.

c. Attitudes and rationaliation.

d. All of the above.

16%') =. The three


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Part (((> Short Essa/ Best!ons

16) 0iscuss the auditors basic process for assessin! business risk and the risk of material

misstatements.

16') 7hy does an auditor use the audit risk modelI 0iscuss the specifications of the audit risk

model and identify the components of the model.

??


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16=) 0iscuss the auditors responsibilities for communicatin! with mana!ement and the audit

committee re!ardin! issues of fraud.

?@


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Part (> Cross+ord PDD&e Chapter * [LO ALL]

1

$

*

, .

0

3 5 17

11

1$ 1*

1, 1.

10

Across' Abbreviation for the component of the audit risk model that a misstatement will not be prevented or detected by controls.

HHHHHH misstatement is the amount of the preliminary ud!ment about account materiality. An auditor would not want to accept an en!a!ement with this non;uantitative level of audit risk.

= The auditor may fail to modify the opinion on materially misstated financial statements.

%% $nintentional misstatements or omissions of amounts or disclosures #two words(.

%' Abbreviation for the component of the audit risk model that assumes no related controls.

% HHHHH procedures are used to evaluate plausible relationships of data.%@ Abbreviation for the component of the audit risk model that the auditor will not detect a material misstatement.

)o+n

% 6ne of the cases presented in the te-tbook.' An auditor holds this desi!nation.

3 HHHHH 5erformance /ndicators #D5/(.

? HHHHH risk is the e-posure that an auditor assumes in a financial statement audit.

@ The A/C5A body that promul!ates auditin! standards used for audits of privately


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Part > To+nsend Off!ce Spp&!es and E4!p%ent [LO ALL]

Chapter *

To+nsend Off!ce Spp&!es and E4!p%ent2or audit en!a!ements with less than four years e-perience, the firms audit risk policy for a

material account is .&3. /nventory is considered a material account. The inherent risk has been setat .:& and control risk was assessed at .?&. Complete the followin!* #%( compute detection riskJ

#'( discuss what detection risk meansJ #3( identify at least two factors that may help e-plain the

assessed level of inherent riskJ and #( usin! ;ualitative terms, classify audit risk #use very low,

low, or moderate( and each of the risk components #use low, moderate or hi!h(.

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CHAPTER *> SEL?@ASSESSMET SOLUT(OS

Part (> Tre or ?a&se Best!ons

16%) ?a&se %. Audit risk is the auditors e-posure to loss or inury of his or her reputation

from events arisin! in connection with financial statements audited.

16%) Tre '. +n!a!ement risk is the auditors e-posure to loss or inury of his or her

reputation from events arisin! in connection with financial statements audited.

16') Tre 3. The components of the audit risk model include inherent risk, control risk and

detection risk.

16') Tre . /nherent risk is the susceptibility of an assertion to material misstatement,

assumin! no related controls.

16') Tre ?. 5rofessional ud!ment must be used when evaluatin! business risk.

16') Tre @. Audit risk and materiality si!nificantly impact the auditors evidence decisions.

16') ?a&se . The risk of a material misstatement includes inherent risk and samplin! risk.

16') Tre :. The combination of inherent risk and control risk is referred to an auditee risk.

16') ?a&se =. /nherent risk includes samplin! risk and nonsamplin! risk.

16%%)?a&se %&. Materiality is the value of an omission in the financial statements that must be

adusted.

Part ((> M&t!p&e Cho!ce Best!ons

16') %. /f internal control over sales and cash receipts is e-cellent, detection risk would be*

a. 0ecreased.

b. $naffected.

c# (ncreased#

d. Cannot be determined from the information provided.

16') '. The audit risk model includes all but the followin! components*

a. 0etection risk.

8# En6a6e%ent r!s"#

c. /nherent risk.

d. Control risk.

16') 3. /nherent risk and control risk are*

a. 2unctions of the en!a!ement risk.

b. 2unctions of uncertainty.

c# ?nct!ons of the ent!t/ and !ts en2!ron%ent#

d. 2unctions of samplin! and nonsamplin! risks.

?=


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16') . The audit risk model is used at the account balance or class of transaction level to*

a. Assess inherent risk and control risk so that detection risk can be determined.

b. +stablish the preliminary ud!ment about materiality #tolerable misstatement(.

c. "et a planned level of audit risk.

d# Foth a and c#

163) ?. 5lanned audit risk for inventory has been set at &.&?. /nherent risk has been set at &.&and control risk was assessed to be &.@&. The detection risk will be set at #rounded(*

a. &.%?.

b. &.%.

c# 7#1$#

d. Cannot be computed based on the information provided.

16) @. The auditor obtains an understandin! of the entity and its environment by performin!

all of the followin! assessment procedures e-cept*

a. /n;uires of mana!ement and others.

8# Co%pte the &e2e& of detect!on r!s"#

c. Analytical procedures.

d. 6bservation and inspections.

16?) . An e-ample of an error is*

a. "tealin! inventory.

b. An intentional omission of a si!nificant transactions.

c# A %!sta"e !n the app&!cat!on of an accont!n6 pr!nc!p&e#

d. +mbelin! cash receipts.

16?) :. Certain conditions are !enerally present when fraud occurs, includin!*

a. /ncentives and pressures.

b. 6pportunities.

c. Attitudes and rationaliation.

d# A&& of the a8o2e#

16%') =. The three


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Part (((> Short Essa/ Best!ons

16) 0iscuss the auditors basic process for assessin! business risk and the risk of material

misstatements.

The ad!tor-s assess%ent of 8s!ness r!s" and the r!s" of %ater!a&s %!sstate%ent ;!#e# the

ad!tor-s r!s" assess%ent process= !nc&des the fo&&o+!n6 steps>

Perfor% r!s" assess%ent procedres to o8ta!n an nderstand!n6 of the ent!t/ and !ts

en2!ron%ent !nc&d!n6 !nterna& contro

(dent!f/ 8s!ness r!s"s that %a/ res&t !n %ater!a& %!sstate%ents !n the f!nanc!a&

state%ents#

E2a&ate the ent!t/-s responses to those 8s!ness r!s"s and o8ta!n e2!dence of the!r

!%p&e%entat!on#

Assess the r!s" of %ater!a& %!sstate%ent at the assert!on &e2e& and deter%!ne the ad!t

procedres that are necessar/ 8ased on the r!s" assess%ent#

16') 7hy does an auditor use the audit risk modelI 0iscuss the specifications of the audit risk

model and identify the components of the model.

The ad!tor ses the ad!t r!s" %ode& as a p&ann!n6 too& to deter%!ne the scope of ad!t!n6

procedres for a part!c&ar accont 8a&ance or c&ass of transact!ons &e2e The %ode& !s

spec!f!ed as>

AR ' (R X CR X )R

+here

AR ' Ad!t r!s" ;the r!s" that the ad!tor %a/ fa!& to %od!f/ the op!n!on

on %ater!a&&/ %!sstated f!nanc!a& state%ents=

(R ' (nherent r!s" ;the sscept!8!&!t/ of an assert!on to %ater!a&

%!sstate%ents ass%!n6 no re&ated contro&s=

CR ' Contro& r!s" ;the r!s" that %ater!a& %!sstate%ents that co&d occr

!n an assert!on +!&& not 8e pre2ented or detected on a t!%e&/ 8as!s 8/

the !nterna& contro&s=

)R ' )etect!on r!s" ;the r!s" that the ad!tor +!&& not detect a %ater!a&

%!sstate%ent that e:!sts !n an assert!on=

@%


26/28

16=) 0iscuss the auditors responsibilities for communicatin! with mana!ement and the audit

committee re!ardin! issues of fraud.

1# To co%p&/ +!th certa!n &e6a& and re6&ator/ re4!re%ents#

$# To a sccessor ad!tor +hen the sccessor %a"es !n4!res !n accordance +!th

AU *1. ;Co%%n!cat!ons 8et+een Predecessor and Sccessor Ad!tors=#

*# (n response to a s8poena#

,# To a fnd!n6 a6enc/ or other spec!f!ed a6enc/ !n accordance +!th re4!re%ents

for the ad!ts of ent!t!es that rece!2e 6o2ern%enta& f!nanc!a& ass!stance#

@'


27/28

Part (> Cross+ord PDD&e Chapter * So&t!on [LO ALL]

1

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C P

*

K

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T O L

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E R A F L E

Y

G

0

A

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3

( G H

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A U ) ( T

17

R ( S K

G ( F

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E R R O R S

E M K

1$

( R E

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A A

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L Y T ( C A L

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10

) R

Across' Abbreviation for the component of the audit risk model that a misstatement will not be prevented or detected by controls.

HHHHHH misstatement is the amount of the preliminary ud!ment about account materiality. An auditor would not want to accept an en!a!ement with this non;uantitative level of audit risk.

= The auditor may fail to modify the opinion on materially misstated financial statements #two words(.

%% $nintentional misstatements or omissions of amounts or disclosures.

%' Abbreviation for the component of the audit risk model that assumes no related controls.

% HHHHH procedures are used to evaluate plausible relationships of data.%@ Abbreviation for the component of the audit risk model that the auditor will not detect a material misstatement.

)o+n

% 6ne of the cases presented in the te-tbook.' An auditor holds this desi!nation.

3 HHHHH 5erformance /ndicators #D5/(.

? HHHHH risk is the e-posure that an auditor assumes in a financial statement audit.

@ The A/C5A body that promul!ates auditin! standards used for audits of privately


28/28

Part > To+nsend Off!ce Spp&!es and E4!p%ent [LO ALL]

Chapter *

To+nsend Off!ce Spp&!es and E4!p%ent2or audit en!a!ements with less than four years e-perience, the firms audit risk policy for a

material account is .&3. /nventory is considered a material account. The inherent risk has been setat .:& and control risk was assessed at .?&. Complete the followin!* #%( compute detection riskJ

#'( discuss what detection risk meansJ #3( identify at least two factors that may help e-plain the

assessed level of inherent riskJ and #( usin! ;ualitative terms, classify audit risk #use very low,

low, or moderate( and each of the risk components #use low, moderate or hi!h(.

1# )R ' AR;(R : CR=

)R ' #7*;#37 : #.7=

)R ' #73

$# A detect!on r!s" of #73 %eans that the ad!tor +!&& esta8&!sh the scope of the

ad!t for !n2entor/ so that there !s on&/ an 3 percent chance that a %ater!a&

%!sstate%ent !f present !s not detected# A &o+ assess%ent for detect!on r!s"!%p&!es that the ad!tor +!&& condct a %ore deta!&ed !n2est!6at!on of th!s accont

than !f the assess%ent of detect!on r!s" +ere h!6h#

*# ?actors that %a/ he&p e:p&a!n +h/ !nherent r!s" +as set h!6h !nc&de>

@ A fe+ !nd!2!da&s do%!nate %ana6e%ent and operat!ons#

@ Co2enant restr!ct!ons assoc!ated +!th &!ne of cred!t#

@ To+nsend !s en6a6ed !n a h!6h&/ co%pet!t!2e !ndstr/#

@ Off!ce )epot !s cons!dered a co%pet!t!2e threat !n "e/ re6!ons#

@ Gross %ar6!n %a/ need to 8e redced for co%pet!t!2e 6o2ern%ent en2!ron%ent#

@ To+nsend cannot !ncrease !ts %ar"et share +!thot add!t!ona& !n2est%ent#

@ Concerns a8ot crrent /ear !n2entor/ o8so&escence# @ S!6n!f!cant LCM !n2entor/ ad9st%ent +as re4!red for pre2!os /ear ad!t#

@ S!6n!f!cant !ncrease !n end!n6 !n2entor/ to fac!&!tate ne+ csto%er#

,# Ad!t R!s" ;AR= ' er/ Lo+#

(nherent R!s" ;(R= ' H!6hI Contro& R!s" ;CR= ' ModerateI and )etect!on R!s"

;)R= ' Lo+#

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Chap03 Study Guide

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