CHAPTER

2
2-1.

AUDIT PLANNING

Audit risk: The risk that the auditor may unknowingly fail to appropriately modify his/her opinion of financial statements that are materially misstated. Inherent risk: Relates to the susceptibility of an account balance or class of transactions to error that could be material. . .assuming that there were no related internal controls. Control risk: The risk that material errors or irregularities are not prevented or detected by the system of internal control. Detection risk: The risk that errors or irregularities which are not prevented or detected by the system of internal control, are not detected by the independent auditor.

2-2.

Study of the business and industry, and application of analytical procedures during the planning stage of the audit assist in evaluating inherent risk. These procedures may permit the auditor to assess inherent risk below the initial 100 assumed level. Sources of business and industry information are the following! a. "anagement in#uiry b. $ermanent audit workpaper file c. %nternal client documents &e.g. correspondence files, minutes, accounting manuals, and policy and procedures manuals' d. $%($) audit and accounting guides e. %ndustry trade publications f. *overnment publications g. (redit reports &+unn , -radstreet, banks, etc.' h. (omputer data bases i. -usiness periodicals a. The audit risk model is )udit risk &)R' . %nherent risk &%R' / (ontrol risk &(R' / +etection risk &+R' b. The audit risk model is useful in managing audit risk for assertions. -y determining planned audit risk for an assertion, assessing inherent and control

2-3.

2-4.

2-2

Solutions Manual to Accompany Applied Auditing, 2006 Edition risks, an auditor can determine the allo a!le detection risk &the amount of detection risk an auditor can allow' for an assertion. )llowable detection risk is used to determine the nature, timing, and e/tent of audit procedures for the assertion.

2-5.

The amount of audit evidence an auditor must gather varies inversely with allowable detection risk. )s allowable detection risk decreases, the amount of evidence re#uired increases, and vice versa. (hapter 0 introduces audit procedures and discusses how auditors modify audit procedures to obtain sufficient competent evidential matter by changing &1' the nature, &0' the timing, or &1' the e/tent of procedures. a. )nalytical procedures are used for these broad purposes! To assist the auditor in planning the nature, timing, and e/tent of other auditing procedures. )s a substantive test to obtain evidential matter about particular assertions related to account balances or classes of transactions. )s an overall review of the financial information in the final review stage of the audit. )n auditors2 e/pectations are developed from the following sources of information! 3inancial information for comparable prior periods giving consideration to know changes. )nticipated results44for e/ample, budgets, forecasts, and e/trapolations. Relationships among elements of financial information within the period. %nformation regarding the industry in which the client operates. Relationships of financial information with relevant nonfinancial information. The factors that influence an auditor2s consideration of the reliability of data for purposes of achieving audit ob5ectives are whether the +ata were obtained from independent sources outside the entity or from sources within the entity. Sources within the entity were independent of those who are responsible for the amount being audited. +ata were developed under a reliable system with ade#uate controls. +ata were sub5ected to audit testing in the current or prior year. 6/pectations were developed using data from a variety of sources. "#$ "%$ "%$ b. b. b. "#$ "%$ "2$ c. c. "%$ "&$

2-6.

b.

c.

2-7. 2-8. 2-9.

a. a. a.

Audit 'lanning 2-10. a. The audit risk model gives the following results! )R . %R / (R / +R &or' +R / )R / &%R / (R' &1' 0.7 &0' 0.9: &1' 1 &8' 1.11 &7' 0.7

2-3

%n the third situation, the auditor does not have to accumulate any evidence because inherent risk and control risk give the appropriate level of planned audit risk. b. &1' 1 &tied' &0' 7 &1' 1 1. &8' 0 &7' 1 &tied'

2-11.

a.

Audit risk is the risk that the auditor may unknowingly fail to appropriately modify an opinion on financial statements that are materially misstated. Inherent risk is the susceptibility of an account balance or class of transactions to error that could be material, when aggregated with error in other balances or classes, assuming that there were no related internal controls. Control risk is the risk that error in an account balance or class of transactions that could be material, when aggregated with error in other balances or classes, will not be prevented or detected on a timely basis by controls. Detection risk is the risk that an auditor2s procedures will lead the auditor to conclude that error in an account balance or class of transactions that could be material, when aggregated with error in other balances or classes, does not e/ist, when in fact such error does e/ist.

0.

1.

%nherent risk and control risk differ from detection risk in that they e/ist independently of the audit of financial statements, whereas detection risk relates to the auditor2s procedures and can be changed at the auditor2s discretion. +etection risk should bear an inverse relationship to inherent and control risk. The less inherent and control risk the auditor believes e/ists, the greater the acceptable detection risk. Materiality is the magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the 5udgment of a reasonable person relying on the information would have been changed or influenced by the omission or

b.

1.

2-4

Solutions Manual to Accompany Applied Auditing, 2006 Edition misstatement. This concept recogni;es that some matters, either individually or in the aggregate, are important for the fair presentation of financial statements in conformity with generally accepted accounting principles whereas other matters are not important. 0. "ateriality is affected by the nature and amount of an item in relation to the nature and amount of items in the financial statements under e/amination, and by the auditor2s 5udgment as influenced by the auditor2s perception of the needs of a reasonable person who will rely on the financial statements.

2-12.

The primary issue raised here is how friendly an auditor should be with client personnel. This situation is especially interesting in light of the auditor2s view of the relationship prior to being assigned significant responsibility. The issue is whether <osie is trying to become friendly in order to try to manipulate the auditor2s decisions.