AFM351 Chapter Notes - Chapter 4: Audit Risk, Financial Statement, Cash Flow

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OC2146671

16 May 2020

School

University of Waterloo

Department

Accounting & Financial Management

Course

AFM351

Professor

Linda Robinson

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Audit risk: risk that an auditor expresses an inappropriate audit opinion when the financial statements

are materially misstated

Inherent risk: the susceptibility of the financial statements to a material misstatement without

consideration of the internal controls

Assertion: statement made by management regarding the recognition, measurement, presentation and

disclosure of items in the FS

Significant risk: an identified and assessed risk of material misstatement that, in the auditor's

judgement, requires special audit consideration

• Involves fraud

• Related to significant economic or accounting developments

• Complex transactions

• Significant related party transactions

• Significant subjectivity in measurement of financial information

• Significant transactions outside the client's normal course of business

Control risk: risk that a client's system of internal controls will not prevent or detect a material

misstatement

The Audit Risk Model and Its Components

• Identify client characteristics that place the financial statements at risk of material misstatement

(inherent risk) and determine if controls were in place and effective (control risk)

• Detection risk: the risk that the auditor's testing procedures will not be effective in detecting a

material misstatement

• Audit risk = inherent risk x control risk x detection risk

• Acceptable audit risk for the financial statements overall is set by the auditor at the beginning of

the audit

o Inverse relationship between assessed level of inherent and control risk and the acceptable

level of detection risk

Materiality: information that impacts the decision-making process of the users of the FS

Qualitative Factors

• Compliance with regulatory requirements

• Compliance with debt covenants or other contractual requirements

• Masks a change in earnings or other trends, general economic and industry conditions

• Incorrect selection or application of an accounting policy that has a material effect on future

periods' FS

• Affects ratios used to evaluate the entity's financial position, results of operations or cash flow

• Has the effect of increasing management compensation

• Significant having regard to the auditor's understanding of know previous communications to

users

• Omission of information not specifically required by the applicable financial reporting framework

but is important to users' understanding of the financial position, financial performance or cash

flows of the entity

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Document Summary

Audit risk: risk that an auditor expresses an inappropriate audit opinion when the financial statements are materially misstated. Inherent risk: the susceptibility of the financial statements to a material misstatement without consideration of the internal controls. Assertion: statement made by management regarding the recognition, measurement, presentation and disclosure of items in the fs. Significant risk: an identified and assessed risk of material misstatement that, in the auditor"s judgement, requires special audit consideration. Involves fraud: related to significant economic or accounting developments, complex transactions. Significant transactions outside the client"s normal course of business. Control risk: risk that a client"s system of internal controls will not prevent or detect a material misstatement. Inverse relationship between assessed level of inherent and control risk and the acceptable level of detection risk. Materiality: information that impacts the decision-making process of the users of the fs.

Related Questions

When planning a financial statement audit, a CPA must understandaudit risk and its components. The firm of Pack & Peckevaluates the risk of material misstatement (RMM) by disaggregatingRMM into its two components: inherent risk and control risk.

Required:

For each illustration, select the component of audit risk that ismost directly illustrated. The components of audit risk may be usedonce, more than once, or not at all.

Note if each illustration below is Control risk, Detectionrisk or Inherent risk

1. A client fails to discover employee fraud on a timely basisbecause bank accounts are not reconciled monthly.
2. Cash is more susceptible to theft than an inventory ofcoal.
3. Confirmation of receivables by an auditor fails to detect amaterial 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 tocontinue operations.

oliverhinoceros960

A424

Homework #3

Due Tuesday, February 28

Worth 100 Points

Note: Students are expected to work independently (i.e., on your own) on all homework assignments. Please type and post to Canvas.

Part I. Risk Assessments

1. 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. (10 points, 1 point each).

Components: Inherent Risk (IR), Control risk (CR), or Detection Risk (DR)

a. A client fails to discover employee fraud on a timely basis because bank accounts are not reconciled monthly.

b. Cash is more susceptible to theft than an inventory of coal.

c. Confirmation of receivables by an auditor fails to detect a material misstatement.

d. Disbursements have occurred without proper approval.

e. There is inadequate segregation of duties.

f. A necessary substantive audit procedure is omitted.

g. Notes receivable are susceptible to material misstatement, assuming there are no related internal controls.

h. Technological developments make a major product obsolete.

i. The client is very close to violating debt covenants.

j. XYZ Company, a client, lacks sufficient working capital to continue operations.

2. Read Case 1.6, Nextcard, Inc. from our Casebook. Pretend you are the auditor for Nexcard, Inc. in the planning phase of the audit for FY 2000 and perform the following risk assessment procedures. That is, just focus on the information in the case prior to the discovery of the fraud (pages 83-86). (50 points total)

a. Perform a risk assessment as part of your audit plan for fiscal year 2000. Set or assess each component/factor of the audit risk model. Describe in detail how you set or assessed each factor (i.e., include specific risk factors from the case and explain how they influenced your assessment). (25 points)

b. Perform a fraud risk assessment for the risk of material misstatement due to fraudulent financial reporting. That is, identify and briefly describe specific fraud risk factors (i.e., more than 1) for each of the three components of the fraud risk triangle, specific to fraudulent financial reporting. (15 points)

c. Identify and describe one significant pervasive risk present during the Nextcard audit. In doing so, explain how the pervasive risk affects the risk of material misstatement. Then, describe how the auditor could respond to that pervasive risk (how could they change the audit plan to address that risk). (5 points)

d. Identify and describe one significant specific risk present during the Nextcard audit. In doing so, explain how the specific risk affects the risk of material misstatement. Then, describe how the auditor could respond to that specific risk (how could they change the audit plan to address that risk). (5 points)

Part II. Evidence and Management Assertions

1. 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. (10 points, 1 point each)

a. sending a written request to the entityâs 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 entityâs warehouse personnel count the raw materials inventory.

h. performing test counts of the warehouse personnelâs count of the raw material.

i. obtaining a letter from the entityâs attorney indicating that there were no lawsuits in progress against the entity.

j. tracing the prices used by the entityâs billing program for pricing sales invoices to the entityâs approved price list.

2. For each of the audit procedures listed above in Part II. 1. (a-j), identify the category (assertions about classes of transactions and events, or assertions about account balances) and identify the primary management assertion being tested. (30 points, 3 points each)

turquoisesheep410

Which of the following statements is most correct regarding the independent auditor's reliance on the tests of controls performed by the internal auditors to reduce their substantive testing?

1-The independent auditor must obtain assurance of the independence of the internal auditors but need not test their work.

2-It is not acceptable for the independent auditor to rely upon the work of the internal auditors.

3-There are no restrictions in relying upon the work of internal auditors.

4-The independent auditor must evaluate the competency and objectivity of the internal auditors and must test a sample of the work of the internal auditors in order to rely upon their work.

The term "materiality" as used in auditing is best described as the

1-substance of the auditing procedures.

2-amount of misstatement on the financial statements that would influence a decision maker.

3-underlying evidence upon which the audit opinion is based.

4-amount of material the auditor gathers as evidence to support the audit opinion.

Prior to accepting an audit client an auditor has a professional obligation to

1-contact the predecessor auditor.

2-perform preliminary analytical review procedures.