Chapter 6: Audit Risk and Materiality and it's Role in Planning the Audit

Question 1

Important concepts in planning an audit

Answer 1

Audit risk and materiality

Question 2

Materiality

Answer 2

size and nature of the misstatements that would affect financial statement users’ decisions about the company, sets threshold for misstatement auditor will consider critical

Question 3

What are audit tests designed to do?

Answer 3

Detect misstatements that exceed materiality threshold

Question 4

Audit risk

Answer 4

probability of audit failure, after audit is completed probability that f/s will be materially misstated and auditor will not know it and issue unqualified opinion telling readers f/s okay

Question 5

Audit Risk Model

Answer 5

1) Decide what level of audit risk is acceptable for audit, 2) Assess likelihood that unaudited f/s contain material misstatements, 3) Plan nature and quantity of audit testing needed to achieve established level of audit risk

Question 6

Functions of audit risk

Answer 6

1) Risk of Material Misstatement, 2) Detection Risk

Question 7

Risk of Material Misstatement

Answer 7

unaudited financial statements contain material misstatement to begin with

Question 8

Detection Risk

Answer 8

audit tests chosen and applied by auditor fail to detect material misstatement that exists in f/s

Question 9

Composition of RMM

Answer 9

Inherent Risk and Control Risk

Question 10

Inherent Risk

Answer 10

probability material error/fraud would occur in development of f/s assuming no internal controls present

Question 11

Control Risk

Answer 11

probability that if there is misstatement in creation of f/s, company’s controls would not detect it and correct it in timely basis

Question 12

What determines audit testing strategy (DR)?

Answer 12

assessed level of RM and AR criteria that has been set

Question 13

Audit Risk Model (mathematically)

Answer 13

AR = (IRxCR (RMM)) x DR

Question 14

Relationship between engagement risk and audit risk

Answer 14

As engagement risk increases, lower probability that audit will be a failure (lower AR)

Question 15

Audit Standards that resolve problems with Audit Model

Answer 15

1) IR or CR can never equal 0%, 2) Some evidence must be collected for all audits

Question 16

Planning Materiality

Answer 16

Total amount of misstatement that is deemed acceptable for the f/s before the auditor will conclude they are materially misstated

Question 17

Tolerable misstatement

Answer 17

allocated materiality to specific financial statement amounts and then used to plan specific audit tests

Question 18

Likely misstatement

Answer 18

computed after audit tests performed, composed of total known misstatements

Question 19

Known misstatement

Answer 19

found through performing specific audit tests and used to arrive at likely misstatement

Question 20

Total likely misstatement

Answer 20

amount that total assets/net income might be off by, combined likely misstatements

Question 21

Comparisons of total likely misstatement to materiality

Answer 21

1) If likely misstatement less than materiality, f/s considered to be fairly stated, 2) If likely misstatement more than materiality, f/s materially misstated

Question 22

Preliminary Planning Phase of Audit

Answer 22

1) Decide on materiality, 2) Decide acceptable level of AR, 3) Identify f/s assertions and set tolerable misstatement, assess RMM, and determine maximum amount of DR allowed for each assertion

Question 23

Audit Test Planning Phase of Audit

Answer 23

Use work from planning phase to decide types and quantities of audit tests to use, specifically 1) Use DR and tolerable misstatement to plan appropriate substantive tests, 2) Use CR to plan appropriate tests of control

Question 24

Perform Audit Tests

Answer 24

find known misstatement and determine whether controls being adequately used

Question 25

Evaluate findings of audit tests

Answer 25

compute likely misstatement and compare it to materiality to determine whether f/s materially misstated