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### 48 Cards in this Set

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 Audit risk formula PDR = AAR / (IR x CR) AAR Acceptable audit risk Acceptable audit risk How willing the auditor is that the financial statements may be materially misstated. and he/she still issued an unqualified opinion. This is usucally set between 1-10%. Lower the acceptable audit risk, the more evidence is needed. Compliment 100-Audit risk. How sure I am. If audit risk is 5% I am 95% sure the statements are not misstated. PDR Planned Detection Risk Planned detection risk The output of the formula. We are trying to figure this out. This is the risk that should a material misstatement exist, the audit evidence will fail to detect it. The risk the quantity of evidence will not detect a misstatement. PBR is a function of how much evidence. What is the relationship of PBR to evidence. They have an inverse relationship. If PBR increases evidence decreases. If PBR decreases evidence increases. Inherent risk Likelihood of a material misstatement in an account or segment without regard to internal controls. So inherent risk of cash much higher than for land. Nobody is going to steal land. What is the relationship between IR and evidence Direct relationship If IR increasese, need more evidence If IR decreases, don't need as much evidence How is IR addressed? IR is addressed by cycle CR Control Risk Control Risk The likelihood a material misstatement won't be prevented or detected by the internal control control systen. Function of the internal control system and how much I rely on them. Control risk and evidence relationship Direct relationshio with evidence. If CR is increased, evidence needed increases If CR decreases, evidence needed decreases. What does it mean if control risk is set at 100%? If control risk is 100% it means we cannot rely on internal controls at all. We have to accumulate TONS of evidence. How is control risk assessed? Assesed by each cycle and each account in a cycle ER Engagement risk Engagement risk Risk that a CPA firm will suffer harm even though the audit opinion is correct. Might or might not affect acceptaable audit risk. This is the company's choice. What is engagement risk closely tied to? Client business risk If engagement risk affects acceptable audit risk what is the relationship? It will have an inverse relationship. What factors affect acceptable audit risk? 1. Reliance by external users 2. Management integrity 3. Likelihood of financial difficulties. What factors affect reliance by external users? 1. Client size 2. Distribution of owners 3. Nature and amount of liabilities If you have a huge loan that decreases acceptable audit risk and increases evidence What factors affect management integrity If there is turnover in key positions, if there are conflicts between managers and owners, if there are conflicts between owners and CPA firms. What are some indicators of financial difficulties 1. Poor liquidity 2. Low profits/steady losses 3. High debt 4. Speculative business nature 5. Competence of management If there is a likelihood of financial difficulties what happens to AAR and evidence? AAR decreases, and more evidence is needed. 9 Factors affecting inherent risk 1. Nature of business or nature of accounts. 2. Results of previous audit. If errors high risk 3. Initial vs. repeat engagement 0 1st year more risky 4. Number of related parties and nature of them. Lots more risk 5. Non-routine transactions 6. Make up of the population (if most A/R overdue more risky) 7. Judgement required to record transactions 8. Factors related to fraud financial reporting 9. Missappropriation of assets What must you do in solving the audit risk formula? 1. originally assess all the risks 2. Plan quantity and nature of evidence gathered (high, medium, low evidence required). 3. Modify audit program as I go. If I find internal control deficient then must revise expectations. Output of formula PBR tells you: 1. The quantity of evidence to gather (relative concept, high, med, low.) 2. Tells level of staff experience required. (High evidence required, high level staff required). 3. Extent of reviews that must be performed. What things affect acceptable audit risk? 1. Reliance by external users 2. Likelihood of financial failure 3. Integrity of management What things affect inherent risk? 1. Nature of business 2. Results of previous audits 3. Initial vs. repeat engagement 4. Related parties 5. Nonroutine transactions 6. Judgement required 7. Factors related to misstatement arising from fraud 8. Makeup of population 9. Misappropriation What things affect control risk? 1. Effectiveness of internal control 2. Planned reliance Inventory significance, inherent risk, audit evidence High, high, high Petty cash significance, inherent risk, audit evidence low, high, low A/P significance, inherent risk, audit evidence High, high, high Prepaid insurance significance, inherent risk, audit evidence low, low, low capital stock significance, inherent risk, audit evidence high, low, low Allowance for doubtful accounts significance, inherent risk, audit evidence low, high, high Planned detection risk Risk audit evidence will fail to detect misstatements exceeding tolerable misstatements What are the 2 key points on planned detection risk? 1. Planned is depentent on the other 3 factors. Only changes if an auditor changes one of the other factors. 2. Planned detection risk determines amount of evidence auditor plans to accumulate, inversely with size of planned detection risk. If detection risk is reduced, more evidence is needed. Inherent risk auditor's assessment that there are material misstatements due to error or fraud before considering effectiveness of internal controls. Internal controls are considered separately in relation to control risk. Audit assurance 1-acceptable audit risk. Engagement risk Risk that the auditor or audit firm will suffer harm after audit completion even though audit was conducted correctly. Such as if the co. declares bankruptcy after there is a high likelihood of the CPA firm being sued even if the audit quality was high. What part of the audit equation does nature of client's business affect? Inherent risk - For example electronic manufacture has more likelihood of inventory obsolesence. Likely affects inventory, Accourns and loans receivable, and property, plant, and equipment. No effect on cash, notes, and mortgages payable. What part of the audit equation does result of previous audit affect? Inherent risk - Misstatements in previous years audit have high likelihood of occurring again because most are systematic in nature and management can be slow about fixing them. Therefore, an auditor is negligent if the results of preceding year's audit are ignored during development of current year's audit program. What part of the audit equation does initial vs. repeat engagement affect? Inherent risk - Auditor's gain knowledge and experience about likelihood of misstatements after auditing a client for several years. The lack of previous years' audit results causes most auditors to assess a higher inherent risk for initial audits than for repeat engagements in which no material misstatements were previously found. What part of the audit equation does related party transactions affect Transactions between parent and subsidiary companies, and those between management and the corporate entity are examples of related party transactions as defined by accounting standards. Because these aren't arms-length transactions they are likely to be misstateed. What part of the audit equation does nonroutine transactions Transactions that are unusual for a client are more likely to be incorrectly recorded than routine transactions because the client often lacks experience recording them. Examples include fire losses, major property acquisitions, and restructuring changes resulting from discontinued operations. What part of the audit equation does makeup of the population have? Often individual items making up the total population also affect the auditor's expectation of material misstatements. MOst auditors use a higher inherent risk for AR where most accounts are significantly overdue than where most accounts are current. What part of the audit equation does factors related to fraud and misappropriation of assets have? It is difficult in concept and practice to separate fraud risk factors into acceptable audit risk, inherent risk , or control risk. To satisfy audit requirements it is more important for auditor to assess risk and respond than to categorize the risk.