Module 2 - Engagement Planning, Obtaining an Understanding of the Client & Assessing Risks

Question 1

Audit Risk is what?

Answer 1

The risk an auditor takes by reporting Fairly Presented FS when they really might not be

Question 2

What is the AR formula?

Answer 2

AR = IR x CR x DR

Audit Risk = Inherent Risk x Control Risk x Detection Risk

Inherent Risk = Nature of situation

Control Risk = Risk that IC will not catch misstatements

Detection Risk = Substantive Risks (Tests of Dollar Amounts) will not catch misstatements

Question 3

What are the steps to taking on a new audit clinet?

Answer 3

1. Decision to Accept
   
   • Evaluate independence & ability to handle
   • Evaluate communications with predecessor auditor (with permission of client)
2. Accept - Must understand client & industry
   
   • Engagement Letter (Summarizes main points of engagement)
   • Determine materiality levels (quantitative & qualitative)
   • Evaluate Risk: AR = RMM x DR
   • Must do risk assessment procedures
   • Further audit procedures (Test of Controls [optional] & Substantive Tests)

Question 4

Risk of Material Misstatement is?

Answer 4

Inherent Risk x Control Risk

Is assessed because it exists outside of the auditor’s control

If RMM is high, then the auditor must work more to lower DR

Question 5

Detection Risk is?

Answer 5

Broken down into three categories

1. Nature - Type
2. Timing - When
   
   • Ex: Auditing at YE will lower DR
3. Extent - Sample size

Manipulated by the auditor

Ex: If RMM is high, then DR must be lowered by more substantive testing
If RMM is low because IC are good, then DR can be higher and fewer substantive testing is needed

Question 6

An Auditor’s Responsibility includes?

Answer 6

Errors & Fraud
- Reasonable Assurance (high level, but not 100%)

Direct Effect Laws & Regulations

• Reasonable Assurance (high level, but not 100%)
• Direct Effect on FS

Other Laws & Regulations (Indirect)

• Operations that do not directly impact the FS
• Less strict than Reasonable Assurance

Question 7

What are two main kinds of Fraud?

Answer 7

1. Fraudulent Financial Reporting
   
   • Usually accomplished by management
2. Fraudulent Missapropriation of Assets
   
   • Usually accomplished by workers

Question 8

What are the characteristics of Fraud?

Answer 8

Fraud Triangle

1. Incentive (Pressure)
2. Opportunity
3. Rationalize (Attitude)

All may be present or only one or two

Question 9

The auditor brainstorms with the engagement team regarding risks that may lead to material misstatement due to fraud that include:

Answer 9

1. Interviews
2. Brainstorming
3. Fraud Risk Factors
4. Analytical Procedures (Look Test)
5. Client Acceptance/Continuance
6. Entity’s Programs & Controls
7. Revenue Recognition/Mgt Estimates/Inventory Quantities (So significant that they are automatically assumed to be a risk)

Question 10

How does an auditor respond to risks?

Answer 10

1. Overall (Personnel, Predictability - be spontaneous so the client does not know what you are going to do)
2. Specific (Nature, Timing, Extent)
3. Test Journal Entries (Look for anything out of the ordinary, especially at YE)
4. Management Override of Controls

Question 11

Directional Testing is what?

Answer 11

1. Completeness (Understatements)
   
   • Source Doc to GL
2. Existence (Overstatements)
   
   • GL to Source Doc

Question 12

Financial Statement Assertions are made up of what?

Answer 12

Transaction Classes
Account Balances
Disclosures

Question 13

Transaction Classes have what categories?

Answer 13

Occurrence - Transactions & events that have been recorded have occurred and pertain to the entity

Completeness - All transactions & events have been recorded

Accuracy - Amounts & other data relating to recorded transactions have been recorded appropriately

Cutoff - Transactions & events have been recorded in the correct accounting period

Classification - Transactions & events have been recorded at the proper amounts

Question 14

Account Balances have what categories?

Answer 14

Existence - Assets, liabilities & equity interest exist

Rights & Obligations - The entity holds or controls the rights to assets, and liabilities are the obligations of the entity

Completeness - All assets, liabilities, and equity interests have been recorded

Valuation & Allocation - Assets, liabilities, & equity interests are included at appropriate amounts

Question 15

Disclosures have what categories?

Answer 15

Occurrence - Disclosed events and transactions have occurred

Rights & Obligations - Disclosed events pertained to the entity

Completeness - All disclosures that should have been included have been included

Accuracy & Valuation - Information is disclosed fairly & at appropriate amounts

Classification & Understandability - Information is presented & described clearly

Question 16

When is an account considered to be in conformity with GAAP?

Answer 16

When all assertions are met for that account

Question 17

Fraud communication responsibility of the auditor:

Answer 17

1. All fraud involving management should be communicated to the audit committee
2. All material fraud should be communicated to the audit committee

Question 18

An Audit Engagement Letter should include:

Answer 18

1. Objectives of the engagement
2. Management’s Responsiblities
3. Auditor’s Responsibilities
4. Limitations of the Audit

Question 19

Types of Misstatements:

Answer 19

1. Factual Misstatements - misstatements for which there is no doubt
2. Judgmental Misstatements - differences arising from the judgment of management for which the auditor deems unreasonable
3. Projected Misstatements - the auditor’s best estimate of misstatements in populations

Question 20

Noncompliance defined:

Answer 20

Acts of omission or commission by the entity either intentional or unintentional which are contrary to the prevailing laws or regulations

Question 21

Significant Risk defined:

Answer 21

Risk of material misstatement that requires special audit consideration

Question 22

The most difficult type of misstatement to detect is?

Answer 22

The nonrecording of transactions

Question 23

The Ultimate Focus of an Audit is what?

Answer 23

The Financial Statements

Question 24

Audit Planning Steps:

Answer 24

1. Communicate with Predecessor Auditor
2. Engagement Letter
3. Preliminary Engagement Activities
   
   • Auditor rechecks independence
4. Develop Overall Stategy
   
   • Characteristics of engagement that define scope
   • Determine reporting objectives (key dates etc)
   • Considering important risk factors that will determine the focus of the audit team’s resources (materiality levels; high risk areas)
5. The Audit Plan
   
   • Risk Assessment Procedures
   • Further Audit Procedures (Tests of Controls; Substantive Testing)
   • Other Audit Procedures (direct communication with entity’s lawyer)
6. Audit Program
   
   • Written program should be used to implement the Audit Plan
7. Timing of Audit Procedures
   
   • Tests for Controls & Substantive Testing may be tested at any time

Question 25

An Auditor will ordinarily not discuss details of procedures necessary to complete the audit with management in what?

Answer 25

The Engagement Letter

Question 26

Basic Auditing Points:

Answer 26

1. Assertions
2. Objectives
3. Procedures