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38 Cards in this Set
- Front
- Back
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audit risk
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the risk that the auditor may unknowingly fail to appropriately modify the opinion on financial statements that are materially misstated
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engagement risk
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is the risk that the auditor is exposed to financial loss or reputation damage from litigation, adverse publicity, or other events arising in connection with financial statements audited and reported on.
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Audit Risk model formula
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MODEL decomposes overall audit risk into three components: inherent risk (IR), control risk (CR), and detection risk (DR):
AR = IR x CR x DR IR x CR = Risk of Material Misstatement (RMM) |
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inherent risk
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is the susceptibility of a relevant assertion to misstatements that could be material, either individually or when aggregated with other misstatements, assuming there are no related controls. IN other words, the likelihood that a material misstatement exists in the financial statements without the consideration of internal control.
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control risk
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The likelihood that an error
or fraud will not get caught by the client’s internal controls. |
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detection risk
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The likelihood that
an error or fraud will not be caught by the auditor’s procedures. |
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auditors can manipulate..
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DR
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auditors cannot manipulate
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CR, IR
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if IR and CR go up...
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DR goes down, and inversely
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Other Factors Affecting Overall Inherent Risk
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Competition
Economy Nature of Industry – cyclical vs. steady Management Style – aggressiveness (tone at the top) Leverage – debt burden, loan covenants Dollar size of the account Liquidity Volume of transactions Complexity of the transactions New accounting pronouncements Subjective estimates |
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Factors affecting control risk include:
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Control environment
The existence (or lack thereof) and effectiveness of control procedures. Monitoring activities (audit committee, internal audit function, etc.). |
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Factors affecting detection risk include:
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Nature, timing, and extent of audit procedures
Sampling risk Risk of choosing an unrepresentative sample. Nonsampling risk Risk that the auditor may reach inappropriate conclusions based upon available evidence (auditor error). |
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The relationship between detection risk and the nature, timing, and extent of audit procedures
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Lower detection risk-
nature-more effective test timing-test performed at year end\ extent-more test Higher detection risk nature-less effective test testing-can be performed at interim extent-fewer tests |
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errors
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are unintentional misstatements or omissions of amounts or disclosures in financial statements
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Management Fraud
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includes intentional misstatements or omissions of amounts or disclosures in financial statements.
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Direct-effect illegal acts
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are violations of laws or government regulations by the company or its management or employees that produce direct and material effects on the financial statements (e.g., violations of tax laws).
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fraud triangle
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incentive/motive, opportunity, rationalization
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motive types
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Economic - Actual or perceived need for money
Pay college tuition, gambling debts, drugs, high lifestyle Egocentric - Committing fraud for personal prestige Psychotic - “Habitual criminal” who steals for the sake of stealing Ideological - Cause is morally superior, justified in making others victims |
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employee behavior: red flags
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Employees don’t appear to sleep enough
Employees drink excessively or use drugs Employees are irritable, defensive, argumentative Employees can’t look people in the eye Employees prefer to work alone or work late Employees live outside of their apparent means |
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accounting behavior: red flags
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Missing documents.
Alterations on documents. Photocopied documents. Second endorsements on checks. Unusual endorsements. Unexplained adjustments to accounts receivable and inventory balances. General ledgers that do not balance. Cash shortages and overages. Excessive voids and credit memos. Customer complaints. Common names or addresses for refunds. Increased past due receivables. Inventory shortages. Duplicate payments. Dormant accounts that have become active. |
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Fraud prevention methods
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Managing people pressures in the workplace
- Counseling services - Hotlines Control procedures and employee monitoring - Job descriptions - Willingness to enforce/prosecute Integrity by example and enforcement - Code of Conduct/Ethics - Background Checks |
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SAS 90: Required steps in consideration of fraud
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Step 1: Audit team discussion
(“brainstorming Step 2: Identify information necessary to assess fraud risk factors Step 3: a. Identify and b. Assess fraud risk factors Step 4: Respond to risk assessment Step 5: Evaluate audit evidence Step 6: Communicate fraud matters Step 7: Document fraud matters |
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Risk Factors: Management’s Characteristics and Influence
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Motivation to engage in fraudulent reporting (stock options, regulatory pressure, etc). Note: pressures could exist to overstate or understate company results.
Management decisions are dominated by an individual or a small group. Very aggressive attitudes toward financial reporting. Single focus on earnings and earnings projections. High turnover of senior management. History of violations. Evasive responses to auditors Frequent disputes with auditors. |
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Risk Factors: Industry conditions
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Profits lag in the industry.
New requirements potentially impair stability or profitability. Saturated market/fierce competition. Declining industry. Rapidly changing industry |
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Risk Factors: Operating Characteristics
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Weak internal control environment.
Cash flow problems/pressure to raise capital Headquarters in a tax haven Complex accounting measurement and presentation issues Difficult-to-audit transactions or balances Significant related-party transactions Inexperienced accounting personnel |
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Required Risk Assessments
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Audit team must presume that improper revenue recognition is a fraud risk.
Identify risks of management override of controls. Examine journal entries and other adjustments (especially year-end entries). Review accounting estimates for biases. Evaluate business rationale for significant unusual transactions. |
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Respond to Assessed Risks
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Overall effect on audit
Assignment of personnel to the audit team Extent, focus, and nature of audit procedures Predictability of auditing procedures Examination of journal entries and other adjustments Retrospective review of prior year accounting estimates Extended procedures - Surprise inventory counts Count the petty cash twice in one day Contract confirmations |
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,materiality
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refers to the magnitude of an omission or misstatement of accounting information that makes it probable that the judgment of a reasonable person relying on the information would be changed or influenced by the omission or misstatement. The emphasis is on user, rather than management or the audit team.
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tolerable misstatement
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is the amount of planning materiality allocated to an account or class of transactions.
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The hierarchy of audit evidence reliability
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higher reliability-inspection of tangible assets, reperformance, recalculation
medium-inspection of records and documents, confirmation, analytical procedures, scanning lower-observation, inquiry |
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Vouching:
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selecting an item for testing from the accounting records (journals or ledgers) and then examining the underlying source document. This approach provides evidence that items included in the accounting records have occured.
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Tracing:
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selecting an item for testing from the population of source documents and then following it into the accounting records (journals or ledgers). This approach ensures that transactions that occured are recorded(completeness) in the accounting records.
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Goals of engagement planning
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Obtain (or update) an understanding of important events that have affected the client and its operations
Identify areas of the engagement that may represent special risks to the public accounting firm. Ensure that the engagement can be completed in a timely fashion |
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Engagement Letter
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Acts as a contract between the client and the auditor.
Issues addressed in the letter generally include: Engagement objectives Responsibilities of management/auditor Engagement limitations Fees Conflict resolution procedures |
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assurance bucket
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must be filled with sufficient appropriate evidence to obtain the level of assurance necessary to support auditors opinion. First begin with risks assessment procedures, then the auditor would conduct control testing, next he performs substantive analytical procedures. Finally evidence obtained through test of details.
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dual purpose test
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test of controls check the operating effectiveness of controls, while substantive tests of transactions are concerned with monetary misstatements
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Analytical Procedures – when are these types of audit tests required?
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Comparison of current-year account balances to those of one or more comparable periods
Horizontal analyses Vertical analyses Comparison of the current-year account balances to anticipated results found in the company’s budgets and forecasts Evaluation of the relationships of current-year balances to other current-year balances for conformity with predicable patterns based on the company’s experience (e.g., ratio analysis) Comparison of the current-year account balances and ratios with similar industry information Study of the relationships of current-year balances with relevant nonfinancial information (e.g., production statistics). |
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preliminary analytical procedures
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are used to assist the auditor to better understand the business and to plan the nature, timing, and extent of audit procedures.
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