The Audit Risk Equation

Front 1

Audit risk formula

Back 1

PDR = AAR / (IR x CR)

Front 2

AAR

Back 2

Acceptable audit risk

Front 3

Acceptable audit risk

Back 3

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.

Front 4

Compliment

Back 4

100-Audit risk. How sure I am. If audit risk is 5% I am 95% sure the statements are not misstated.

Front 5

PDR

Back 5

Planned Detection Risk

Front 6

Planned detection risk

Back 6

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.

Front 7

What is the relationship of PBR to evidence.

Back 7

They have an inverse relationship. If PBR increases evidence decreases. If PBR decreases evidence increases.

Front 8

Inherent risk

Back 8

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.

Front 9

What is the relationship between IR and evidence

Back 9

Direct relationship
If IR increasese, need more evidence
If IR decreases, don't need as much evidence

Front 10

How is IR addressed?

Back 10

IR is addressed by cycle

Front 11

CR

Back 11

Control Risk

Front 12

Control Risk

Back 12

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.

Front 13

Control risk and evidence relationship

Back 13

Direct relationshio with evidence. If CR is increased, evidence needed increases
If CR decreases, evidence needed decreases.

Front 14

What does it mean if control risk is set at 100%?

Back 14

If control risk is 100% it means we cannot rely on internal controls at all. We have to accumulate TONS of evidence.

Front 15

How is control risk assessed?

Back 15

Assesed by each cycle and each account in a cycle

Front 16

ER

Back 16

Engagement risk

Front 17

Engagement risk

Back 17

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.

Front 18

What is engagement risk closely tied to?

Back 18

Client business risk

Front 19

If engagement risk affects acceptable audit risk what is the relationship?

Back 19

It will have an inverse relationship.

Front 20

What factors affect acceptable audit risk?

Back 20

1. Reliance by external users
2. Management integrity
3. Likelihood of financial difficulties.

Front 21

What factors affect reliance by external users?

Back 21

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

Front 22

What factors affect management integrity

Back 22

If there is turnover in key positions, if there are conflicts between managers and owners, if there are conflicts between owners and CPA firms.

Front 23

What are some indicators of financial difficulties

Back 23

1. Poor liquidity
2. Low profits/steady losses
3. High debt
4. Speculative business nature
5. Competence of management

Front 24

If there is a likelihood of financial difficulties what happens to AAR and evidence?

Back 24

AAR decreases, and more evidence is needed.

Front 25

9 Factors affecting inherent risk

Back 25

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

Front 26

What must you do in solving the audit risk formula?

Back 26

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.

Front 27

Output of formula PBR tells you:

Back 27

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.

Front 28

What things affect acceptable audit risk?

Back 28

1. Reliance by external users
2. Likelihood of financial failure
3. Integrity of management

Front 29

What things affect inherent risk?

Back 29

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

Front 30

What things affect control risk?

Back 30

1. Effectiveness of internal control
2. Planned reliance

Front 31

Inventory significance, inherent risk, audit evidence

Back 31

High, high, high

Front 32

Petty cash significance, inherent risk, audit evidence

Back 32

low, high, low

Front 33

A/P significance, inherent risk, audit evidence

Back 33

High, high, high

Front 34

Prepaid insurance significance, inherent risk, audit evidence

Back 34

low, low, low

Front 35

capital stock significance, inherent risk, audit evidence

Back 35

high, low, low

Front 36

Allowance for doubtful accounts significance, inherent risk, audit evidence

Back 36

low, high, high

Front 37

Planned detection risk

Back 37

Risk audit evidence will fail to detect misstatements exceeding tolerable misstatements

Front 38

What are the 2 key points on planned detection risk?

Back 38

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.

Front 39

Inherent risk

Back 39

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.

Front 40

Audit assurance

Back 40

1-acceptable audit risk.

Front 41

Engagement risk

Back 41

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.

Front 42

What part of the audit equation does nature of client's business affect?

Back 42

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.

Front 43

What part of the audit equation does result of previous audit affect?

Back 43

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.

Front 44

What part of the audit equation does initial vs. repeat engagement affect?

Back 44

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.

Front 45

What part of the audit equation does related party transactions affect

Back 45

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.

Front 46

What part of the audit equation does nonroutine transactions

Back 46

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.

Front 47

What part of the audit equation does makeup of the population have?

Back 47

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.

Front 48

What part of the audit equation does factors related to fraud and misappropriation of assets have?

Back 48

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.