Chapter 7

Question 1

What is the audit risk model?

What is the audit risk model equation?

Answer 1

The audit risk model is a planning tool for the auditor. The primary objective of applying the model is to help the auditor assess the amount and type of audit evidence to gather and evaluate.

Audit risk = Inherent Risk X Control Risk X Detection Risk

Question 2

What is audit risk?

Answer 2

Audit risk is the measure of the level of risk that the auditor is willing to accept that the financial statements may be materially misstated after the audit is completed and a standard (unqualified) audit opinion has been issued.

Question 3

If the auditor wants to achieve high degree of confidence that there are no undetected material errors remaining in the financial statements then the auditor will?

Answer 3

The auditor will want a low risk of missing the errors during the audit and arriving at a wrong conclusion therefore the auditor will want to establish audit risk as low. they want to minimize the chances of missing the errors. If the auditor wants to minimize the risk of missing errors it follows the auditor will gather more audit evidence.

Question 4

It is important to recognize that there’s an inverse relationship between audit risk and audit evidence. Explain the relationship.

Answer 4

The lower the audit risk or the higher assurance required by the auditor, the auditor will have to perform more work. a lower audit risk may also require more persuasive evidence be gathered.

Question 5

What factors does the auditor consider in the determination of audit risk?

Answer 5

Three factors are considered:
1) The degree to which external users rely on the statements.

The more widespread the users are the greater harm that can result from users relying on inaccurate information. Therefore the more users, the lower the audit risk should be assessed. Factors that should be considered in assessing uses reliance on the financial statements are:
-clients size: usually the larger the client the more users, therefore the lower the audit risk should be.
-distribution of ownership. Public companies typically have more widespread ownership than private companies. Therefore typically audit risk is assessed lower on public companies than for private companies.
_nature and amount of liabilities. If a company has many creditors, versus a company with only one creditor like a bank loan, the auditor would want to assess a lower audit risk for that company with the more creditors.

2) The likelihood that a client will have financial difficulties after the auditors report is issued.

The more likely the client will face financial difficulties, the more likely investors and creditors will be financially harmed and therefore there is a greater risk to the auditor of being sued even if the financial statements are not misstated. Therefore it is logical that the auditor will want to establish a lower audit risk. There are several factors the auditor would consider in assessing the potential for financial difficulty and they include:

• liquidity position: If the company has poor working capital then there is a greater chance they will not be able to make their obligations and therefore will suffer financial difficulty.
• if a company has several years of losses there is a greater chance of cash flow problems and the company facing financial difficulty.
• the method of financing growth. If the company typically finances through debt then there will be a greater chance of not being able to make its debt payments
• nature of operations
• extent of reliance on technology
• management competence

3) management integrity

If management lacks integrity there is a greater chance of misstatement. Therefore it follows the auditor will want to establish a lower audit risk and therefore do more audit work so as to be confident material misstatements are detected by the auditor.

Question 6

What is inherent risk? Provide an example.

Answer 6

Inherent risk is a measure of the auditor’s assessment of the likelihood that there are material misstatements before considering effectiveness of internal controls.
It is susceptibility of errors before considering any internal controls to reduce the risk of error.

For example, an account that requires estimating has a higher risk of being misstated than an account for which the amount is known for certain. The amount of warranty liability that should be accrued by a company requires an estimate based on several factors such as sales, future cost of repairs, historical experience and maybe the changes in the product. The warranty liability is essentially a forecast of amounts that will be paid in the future. Warranty liabilities has a higher risk of misstatement due to the nature of the account than say an account like prepaid insurance. The amount paid for the insurance is known as well as the length of the insurance policy. Therefore there is minimal uncertainty as to the amount of the prepaid insurance on the balance sheet. Warranty liabilities due to their nature are more susceptible to misstatement than prepaids and therefore should be assessed a higher inherent risk.

Inherent risk is assessed for the financial statements as a whole and at the account balance level.

Question 7

In inherent risk, high chance of errors means?

Answer 7

Hi chance of errors means high inherent risk. The higher the inherent risk, likely the more audit evidence the auditor will have to gather.