Lecture 5 Flashcards
What is the substantive approach, and what are its problems?
Definition: Focuses on directly testing financial statement balances and transactions to identify material misstatements. Two methods:
Tests of Detail (ToDs): Line-by-line verification of transactions with supporting documentation.
Substantive Analytical Procedures (SAPs): Developing independent expectations for balances and reconciling differences.
Problems:
Time-intensive and costly for large entities with automated transactions.
SAPs depend on accurate and reliable benchmarks, which may not always be available.
How addressed:
Use of data analytics for large datasets.
Combining ToDs and SAPs to optimize resources and reduce costs.
Example:
Tests of Detail (ToDs): Verifying sales transactions by checking invoices and delivery notes.
SAPs: Estimating revenue based on sales trends and comparing it to reported revenue.
What is the systems/controls approach, and what are its problems?
Definition: Relies on evaluating the operating effectiveness of internal controls to reduce substantive testing.
Focuses on areas like segregation of duties, authorization controls, and IT system safeguards.
Problems:
Over-reliance on controls testing can lead to missing errors if controls are poorly designed.
Ineffective for organizations with weak or non-existent controls.
How addressed:
Combine with substantive testing for high-risk areas.
Use automated tools to verify IT controls and ensure compliance.
Example:
Testing segregation of duties in cash-handling processes to ensure no single person controls the entire transaction.
Using automated tools to verify user access controls in IT systems.
What is the balance sheet approach, and what are its problems?
Definition: Focuses on verifying year-end account balances, assuming that if these balances are correct, profit will also be accurate.
Most suitable for small or asset-heavy entities (e.g., property companies).
Problems:
Neglects income statement accounts, potentially missing timing errors (e.g., cut-off issues).
Unsuitable for industries with high transaction volumes.
How addressed:
Transition to risk-based approaches that address both balance sheet and income statement risks. Example:
Verifying inventory balances at year-end but ignoring issues in revenue recognition throughout the year.
Transitioning to test income statement items like revenue and expenses in a retail business.
What are analytical procedures, and what are their problems?
Definition: Evaluates relationships among financial and non-financial data to identify anomalies or inconsistencies.
Example: Comparing payroll costs to the number of employees or analyzing trends in gross margins.
Problems:
Requires robust independent expectations and reliable data.
Limited use for low-volume, high-value transactions or subjective balances.
How addressed:
Use as part of a broader substantive approach for high-volume accounts.
Combine with other methods like ToDs for greater reliability.
Example:
Comparing payroll costs to the number of employees to identify unusual trends.
Analyzing gross profit margins year-over-year to detect potential understatement of expenses.
What is the audit risk approach, and what are its problems?
Definition: Focuses on minimizing audit risk
AuditRisk=InherentRisk×ControlRisk×DetectionRisk).
Concentrates efforts on areas of higher inherent and control risks.
Problems:
Requires significant judgment to assess risks accurately.
Flawed risk assessments can lead to over-testing or under-testing.
How addressed:
Adoption of standardized risk frameworks (e.g., ISA 315).
Use of data analytics to refine risk assessments and testing focus.
Example:
High inherent risk in complex estimates like goodwill impairment in a tech company.
Increased control risk due to weak segregation of duties in a small business.
What is the business risk approach, and what are its problems?
Definition: Focuses on identifying risks that could prevent the business from achieving its objectives and assessing their impact on the financial statements.
Includes strategic, operational, financial, and compliance risks.
Problems:
Over-reliance on analytical review and management inquiries.
Risks identified may not always translate into audit risks, leading to inefficiencies.
How addressed:
Integrated into the audit risk approach, focusing on risks that directly impact the financial statements.
Regulatory changes (e.g., SOX) have increased focus on financial statement risks rather than broader business risks.
Example:
Business risk: Regulatory changes affecting the healthcare industry’s compliance costs.
Audit risk: Misstatement of provisions or liabilities due to new regulations.
What is the existence assertion in auditing inventory?
Definition: Ensures that inventory recorded in the financial statements physically exists.
Audit Test Example: Perform a physical stock count at year-end to verify the existence of inventory items.
What is the completeness assertion in auditing inventory?
Definition: Ensures that all inventory that should be recorded is included in the financial statements.
Audit Test Example: Review receiving reports and production records to ensure all inventory items are properly recorded.
What is the rights and obligations assertion in auditing inventory?
Definition: Ensures the company has ownership rights to the inventory and that it is free from liens or obligations.
Audit Test Example: Inspect title deeds or purchase invoices to confirm ownership and check for pledged inventory agreements.
What is the valuation assertion in auditing inventory?
Definition: Ensures inventory is valued correctly (e.g., at the lower of cost or net realizable value).
Audit Test Example: Recalculate the inventory valuation using cost and compare to selling price to confirm compliance with the lower of cost or NRV principle.
What is the cut-off assertion in auditing inventory?
Definition: Ensures inventory transactions are recorded in the correct accounting period.
Audit Test Example: Inspect goods received and dispatched near year-end to confirm they are recorded in the appropriate period.
What is the presentation and disclosure assertion in auditing inventory?
Definition: Ensures inventory is presented appropriately in the financial statements and that all required disclosures (e.g., methods of valuation) are made.
Audit Test Example: Check the financial statement notes to ensure inventory valuation methods (e.g., FIFO, LIFO) are disclosed as per applicable standards.
