Chapter 4: Risk Assessment

Question 1

Audit Risk

Answer 1

The risk that an auditor expresses an unqualified opinion on materially misstated financial statements

Question 2

Two levels of Audit Risk

Answer 2

1. Financial Statement Level
2. Individual account balance or class of transactions level

Question 3

Audit Risk Model

Answer 3

IR x CR x DR = AR

Inherent Risk
Control Risk
Detection Risk

Question 4

Inherent Risk

Answer 4

Susceptibility of an assertion about a class of transaction, account balance or disclosure to a misstatement due to error or fraud that could be material, either individually or when aggregated with other misstatements, before consideration of any related controls

IS ALWAYS THERE BECAUSE OF THE NATURE OF BUSINESS

Question 5

Control Risk

Answer 5

The risk that a misstatement that could occur in an assertion about a class of transaction, account balance, or disclosure and that could be material, either individually or when aggregated with other misstatements

WILL NOT BE PREVENTED, or detected or corrected, on a timely basis by the entity’s internal control

CONTROLLED BY MANAGEMENT TO CONTROL INHERENT

Question 6

Detection Risk

Answer 6

The risk that the procedures performed by the auditor to reduce audit risk to an acceptably low level will not detect a misstatement that exists and that could be material, either individually or when aggregated with other misstatements

CONTROLLED BY AUDITORS

IS NEVER 0

Question 7

What is detection risk determined by?

Answer 7

The effectiveness of the audit procedures and how well the procedures are applied by the auditor

Question 8

Examples of heightened Inherent Risk

Answer 8

Transaction complexity, and the adoption of new accounting standards

Question 9

Examples of heightened Control Risk

Answer 9

The creation of new controls or the implementation of a new accounting information system

Question 10

Risk of Material Misstatement

Answer 10

Combination of IR and CR, Auditors have little to no control over this

Question 11

Steps for using the Audit Risk Model

Answer 11

1. Set a planned level of audit risk such that an opinion can be issued on the financial statements
2. Assess the risk of material misstatement (IRxCR)
3. Use the audit risk equation to solve for the appropriate level of detection risk:
   DR = AR/IRxCR

Question 12

Engagement Risk

Answer 12

An auditor’s exposure to financial loss and damage to professional reputation

Question 13

Business risks

Answer 13

Risks that result from significant conditions, events, circumstances or actions that impair management’s ability to execute strategies

Question 14

What do you need to understand about the entity and it’s environment?

Answer 14

• Nature of the Entity
• Industry, Regulatory and External Factors
• Internal Control
• Objectives, Strategies, and Business Risks
• Entity Performance Measures

Question 15

Two types of Material Misstatemens

Answer 15

1. Errors
2. Fraud

Question 16

Errors

Answer 16

Unintentional misstatements

Question 17

Fraud

Answer 17

Intentional misstatements

Question 18

Two types of fraud

Answer 18

1. Fraudulent financial reporting (higher in materiality)
2. Misappropriation of Assets (Could also be highly material)

Question 19

Example of Fraudulent Financial Reporting

Answer 19

Fraudulent journal entries (violating GAAP)

Question 20

Examples of Misappropriation of asset

Answer 20

• Theft (keeping a company laptop)
• CEO misusing assets to live a lavish life

Question 21

If someone were to create a fraudulent JE to cover theft, is that fraudulent financial reporting or misappropriation of asset?

Answer 21

Misappropriation of asset

Question 22

What makes up the fraud triangle

Answer 22

• Incentives/Pressures
• Opportunities
  -Attitudes/Rationalization

Question 23

Fraudulent Financial Reporting Fraud Triangle Examples

Answer 23

Incentive/Pressure:
- Financial profitability is threatened by economic conditions
- High degree of competition
- Significant financial interests in the entity

Opportunities:
- Ineffective audit committee oversight over the financial reporting
- Asset or Revenue based on significant estimates that involve subjective judgments

Attitudes/Rationalizations:
- Communication of inappropriate values or ethical standards
- Known history of violations of security laws

Question 24

Misappropriation of Asset Fraud Triangle Example

Answer 24

Incentives/Pressure:
- Personal financial obligations
- Adverse relationship between entity and employees

Opportunities:
- Inadequate internal control over assets
- Certain circumstances (large amount of cash on hand)

Attitudes/Rationalizations:
- Disregards for the need for monitoring
- Behavior indicating dissatisfaction with the company

Question 25

How do we assess fraud risk

Answer 25

Brainstorming meeting with engagement team to go over fraud triangle and come up with possible fraudulent activities, and susceptible areas. Based on that, design procedures to assess risks of fraud

Question 26

How to lower detection risk

Answer 26

Reduced by conducting additional substantive tests, adequate planning, assigning the most experienced staff to an audit, application of professional skepticism, supervision and review of audit work performed, supervision and conduct of a firm’s audit practice in accordance with appropriate quality control standards

Examples of tests: Classification testing, Completeness testing, Occurrence testing, Valuation testing