Ch 5 - audit evidence and documentation Flashcards
risk, evidence, tests
The risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated
Audit risk
Auditor’s opinion is materially misstated, reality is no material misstatement
Type 1 Error (false positive)
A type 1 error is also referred to as an…
Inefficient outcome (because it leads to additional work/client/investor concerns and costs that are not necessary)
Auditor’s opinion is no material misstatement, reality is materially misstated
Type 2 Error (false negative)
A type 2 error is also referred to as an…
Ineffective audit/outcome (because the audit is set up to minimize Audit Risk, yet the auditor didn’t)
Which error type is worse?
Type 2 Error (worse since there actually were material misstatements that weren’t caught)
What is an auditor’s main objective?
To conduct the audit of financial statements in a manner that reduces audit risk to an appropriately low level
T/F: Type 2 errors lead to opportunity costs.
False; Type 1 errors because they missed out on investing in that company when the auditor gave the wrong opinion (less wealthy)
Those suffered by not taking an action; what you miss out on by doing something else instead.
Opportunity costs
T/F: Audit Risk is a function of the risk of material misstatement and detection risk
True
Audit Risk (AR) equations:
AR = risk of material misstatement * detection risk
OR
AR = inherent risk * control risk * detection risk
Risk of material misstatement equation:
Risk of material misstatement = inherent risk * control risk
The susceptibility of an assertion to a misstatement, due to error or fraud, that could be material, individually or in combination with other misstatements, before consideration of any related controls; How likely a material misstatement is based on its nature
Inherent risk
(some accounts, clients, or assertions are inherently more likely to produce misstatements than others)
The risk that a misstatement, due to error or fraud, could occur in an assertion and could be material, individually or in combination with other misstatements, will not be prevented or detected on a timely basis by the company’s internal controls; the likelihood that the controls would not catch/correct a material misstatement.
Control risk
(The effectiveness of the design and operation of internal controls)
The risk that the procedures performed by the auditor will not detect a misstatement that exists and that could be material, individually or in combination with other misstatements.
Detection risk
T/F: An auditor sets the control and inherent risks.
False; the auditor sets the detection risk; the auditor assesses the control and inherent risks because they are what they are
The auditor sets the detection risk to…
To whatever is needed to keep audit risk low
T/F: Detection Risk is the only piece the auditor directly influences.
True
(auditor can’t influence control or inherent risk)
Given: Audit Risk is set at 5%, Inherent Risk is assessed at 50%, Control Risk is assessed at 40%.
What does Detection Risk need to be set to?
Algebra equation:
5% = 50% * 40% * D
5%/20% = 20%D/20%
D = 25%
(Detection Risk must be set to 25% or lower to keep Audit Risk at 5% or lower)
The lower the percentage…
The less risk there is
Given: Audit Risk is set at 5%, Inherent Risk is assessed at 80%, Control Risk is assessed at 50%.
What does Detection Risk need to be set to?
5% = 80% * 50% * D
5% = 40%D
D = 12.5%
** if inherent and control risk are high, detection risk must be low
(Low) Audit Risk = Inherent Risk 🡩 * Control Risk 🡫 * Detection Risk?
Net effect of inherent and control risk will determine detection risk (if net is high, detection risk is low; if net is low, detection risk can be higher)
T/F: Both inherent risk and control risk have an inverse relationship with detection risk.
True; if control risk is high, detection risk is low; if inherent risk is high, detection risk is low (vice versa)
Where does audit evidence come from (5)?
in short: Everywhere
1. The client
2. Peer companies
3. In-house experts
4. The news
5. Your friends
T/F: Auditors must obtain sufficient and appropriate audit evidence.
True
The measure of the quantity of audit evidence.
Sufficiency (enough evidence –> subjective)
The measure of the quality of audit evidence, i.e., its relevance and reliability.
Appropriateness (good evidence that is BOTH relevant and reliable)
The relationship to the assertion or to the objective of the control being tested.
Relevance (must be related to the fundamental assertion being tested)
This depends on the nature and source of the evidence and the circumstances under which it is obtained.
Reliability (non-binary, there is a spectrum of reliability)
** least reliable evidence is verbal assertions by the client
5 things that make evidence more reliable:
- Documentary evidence (vs verbal evidence)
- Original documents (not copies)
- Good control environment
- Comes from outside the client (i.e. bank confirmations)
- Provided directly to the auditor (from outside the client)
T/F: There is an inverse relationship between the required (subjective) levels of Sufficiency and Appropriateness.
True; if your evidence is extremely good (high Appropriateness) you don’t need as much of it (lower Sufficiency).
T/F: Lower Materiality (concerned with smaller misstatements) –> Higher Requirement for Sufficiency
True
T/F: Lower Risk of Material Misstatement –> Higher Requirement for Sufficiency
False; Greater risk of material misstatement requires higher sufficiency
8 Ways auditors collect evidence:
IROC-RATI acronym:
1. Inspection - reading documents
2. Recalculation - testing mathematical accuracy
3. Observation - shadowing
4. Confirmations - 3rd party
5. Reperformance - testing internal controls
6. Analytical procedures
7. Tying
8. Inquiry – Interviews/questionnaires
Connections/paths from Source Documents to the financials is often referred to as…
an Audit Trail
When you start with a Source Document and tie it forward to the Financial Statements.
Tracing
(trace in sd)
When you start with a Financial Statement item and tie it backward to the related Source Documents.
Vouching
(vouch for fs)
T/F: Tracing is used to test Completeness (when concerned about understatements of liabilities)
True; want to make sure client includes liabilities provided by source docs on f/s
T/F: Vouching is used to test Valuation/Allocation (to ensure $ values are correct)
False; Vouching is used to test Existence/Occurrence when concerned about overstatements of assets (want to make sure client’s assets on f/s actually exist/occur in source docs)
3 Types of audit procedures:
1) Risk assessment procedures: identify the riskiest depts/accs/areas of financial statements
2) Test of controls: to verify if Internal Controls are operating effectively
3) Substantive procedures: to look for $ value Material Misstatements
Common risk assessment procedures (4 audit procedures):
- Inquiries
- Observations
- Inspections
- Analytical procedures
Common IC Testing Procedures (2 audit procedures):
- Reperformance
- Observation
Common Substantive Procedures (4 audit procedures):
- Tying
- Recalculation
- Confirmations
- Analytical procedures
Substantive Procedures that aren’t Analytical Procedures
Test of details
Tests of Details that focus on the ending balance in an account. (ex: for cash and inventory)
Test of balances
Tests of Details that focus on testing the transactions in an account. (ex: for sales)
Test of transactions
A test that qualifies as both an Internal Control Test and a Substantive Procedure.
Dual purpose test
(ex: verifying Bank Reconciliations are prepared correctly)
Records kept by the auditor of the procedures applied, the tests performed, the information obtained, and the pertinent conclusions reached in the engagement. The main method of documentation for audits
Workpapers
6 Examples of workpapers:
- audit programs
- analyses
- memoranda
- letters of confirmation and representation
- abstracts of company documents
- schedules or commentaries prepared/obtained by the auditor
What components are included in a workpaper?
- client name, description, date
- index
- preparer and reviewer ID
- tickmarks and tickmark legend
- notes describing what the auditor did
- auditor’s conclusion
Workpapers are stored in an…
Audit file
Workpapers that don’t typically change from year to year are stored in a…
Permanent file (e.g., the company’s Board of Director bi-laws)
T/F: Workpapers are confidential but not privileged.
True; clients don’t normally have access to them but governing bodies are allowed to request for workpapers
