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CHAPTER 5

Overview of the Financial
Statement Audit
Learning Check
5-1.

5-2.

a.

The overall objective of a financial statement audit is the expression of an opinion
on whether the client's financial statements are presented fairly, in all material
respects, in conformity with GAAP.

b.

The six phases of a financial statement audit are:

a.

Phase I: Perform Risk Assessment Procedures.

Phase II: Assess the Risk of Material Misstatement.

Phase III: Respond to Assessed Risks.

Phase IV: Perform Further Audit Procedures.

Phase V: Evaluate Audit Evidence.

Phase VI: Communicate Audit Findings.

The five categories of management's financial statement assertions are (1)
existence or occurrence, (2) completeness, (3) rights and obligations, (4) valuation
or allocation, and (5) presentation and disclosure.

Assertions about existence or occurrence deal with whether assets or
liabilities exist at a given date and whether recorded transactions have
occurred during a given period.

Assertions about completeness deal with whether all transactions and
accounts that should be presented in the financial statements are so included.

Assertions about rights and obligations deal with whether assets are the rights
of the entity and liabilities are the obligations of the entity at a given date.

Assertions about valuation or allocation deal with whether asset, liability,
revenue, and expense components have been included in the financial
statements at appropriate amounts.

Assertions about presentation and disclosure deal with whether particular
components of the financial statements are properly classified, described, and
disclosed.

5-3.

b.

Misstatements resulting from the existence or occurrence assertion result in the
recording of transactions that should not have been recorded. For example,
recognizing revenue when the criteria for revenue recognition are not met.
Misstatements resulting from the completeness assertion result from the failure to
record transactions, such as failing to record payables and related expenses.
Completeness problems will never be found by taking a sample from journals of
original entry and going back to source documents.

c.

The four aspects of the presentation and disclosure assertion are:

Occurrence and rights and obligations.

Completeness.

Classification and understandability.

Accuracy and valuation.

a.

Understanding the entity’s regulatory environment and other factors includes
obtaining knowledge about the entity’s industry condition, such as the competitive
environment, supplier and customer relationships, and technological
developments; the regulatory environment including relevant accounting
pronouncements, and the legal and political environment, and factors such as
general economic conditions. This knowledge helps the auditor develop
expectations of the financial statements and identify accounts that may contain
material misstatements. For example, if a company is competing in an industry
where overall economic performance is weak, it may create an incentive for
management to attempt to obtain strong reported financial results with
inappropriate accounting rather than with underlying economic results.

b.

Understanding the nature of the entity includes understanding the entity’s
operations, it ownership, the types of investments that it is making and plans to
make, and the way the entity is structured and how it is financed. For example,
knowledge that the entity engages in a number of long-term construction contract
may alert the auditor to the risk associated accounting estimates needed to apply
the percentage of completion method in preparing the financial statements.

c.

An entity’s objectives, strategies and related business risks are defined as follows.

An entity’s objectives are the overall plans for the entity as defined by those
charged with governance and management.
 Strategies are the operational approaches by which management intends to
achieve its objectives.
 Business risks result from significant conditions, events, circumstances, or
actions, that could adversely affect the entity’s ability to achieve its objectives
and execute its strategies.
Business risks often have financial consequences. The auditor uses this
knowledge to make sure that the financial consequences of an entity’s objectives,
strategies, and related business risks are recorded in the financial statements.

d.

Understanding the management and review of the entity’s financial performance
includes understanding the process of managing the entity’s process and
reviewing outcomes against goals. For example, management often uses internal
measures to obtain information about progress toward meeting the entity’s
objectives. Understanding how management monitors is own progress may alert
the auditor to assertions that may be misstated. If management uses an unusually
strong incentive compensation play to generate sales, it may also create the
incentive for potential revenue recognition problems.

5-4.

Materiality is defined by the FASB as: The magnitude of an omission or misstatement of
accounting information that, in the light of surrounding circumstances, makes it probable
that the judgment of a reasonable person relying on the information would have been
changed or influenced by the omission or misstatement. The concept of materiality helps
the auditor make decisions about issues that are important to the audit, and those that are
not. First, the concept of materiality is important to the audit as it guides the auditor on
important decisions related to the collection of evidence. The auditor usually needs more
evidence about items that are more material, and less evidence is usually needed for items
that are less material. Second, materiality guides the auditor in the evaluation of audit
findings. The auditor will usually discuss immaterial errors with a client, but the auditor
may not require that the financial statements be changed for immaterial misstatements.
If projected errors are material the client should either modify the financial statements or
the auditor will have to issue a qualified opinion on the financial statements.

5-5.

a.

Audit risk is the risk that the auditor may unknowingly fail to modify his or her
opinion on financial statements that contain a material misstatement.

b.

The three components of audit risk; inherent risk, control risk and detection risk
are defined as follows:

Inherent risk is the susceptibility of an assertion to a material misstatement,
assuming that there are no related internal controls.

Control risk is the risk that a material misstatement that could occur in an
assertion will not he prevented or detected on a timely basis by the entity's
internal control structure policies or procedures.

Detection risk is the risk that the auditor will not detect a material
misstatement that exists in an assertion.

c.

Fraud risk factors may relate to either inherent risk or control risk. For example,
when one considers the elements of the fraud triangle, the incentives, pressures
and rationalization that may lead to fraud are similar to inherent risk factors in an
entity. The opportunity for fraud is usually created by a weak system of internal
control or may be closed off by a strong system of internal control.

d.

The auditor uses the audit risk model to make decisions about audit evidence.
The auditor usually makes decisions about overall audit risk, inherent risk, and
control risk and then solves for detection risk. The auditor needs evidence to
support inherent risk and control risk assessment if they are assessed below the
maximum. The higher the level of detection risk that result, the less evidence the

auditor needs to collect from substantive tests. However, if inherent and control
risks are assessed at high or at the maximum, detection risk will be low and
require that the auditor collect more evidence through substantive tests.
5-6.

a.

Fraudulent financial reporting represents the intentional misapplication of
accounting principles to achieve particular reported financial results. WorldCom
engaged in fraudulent financial reporting when it reported items that should have
been expensed as investing in long-term assets. Misappropriation of assets
involves the unauthorized use or theft of an entity’s assets. Common examples of
misappropriation of assets include employee theft of inventory or the
misappropriation of cash.

b.

The three risk factors related to the risk of fraud are:
o The opportunity to commit fraud.
o Incentives or pressures to engage in fraud.
o The ability to rationalize fraud as being acceptable behavior.

5-7.

The auditor uses his or her knowledge of the system of internal control to:
1. Identify types of potential misstatements.
2. Consider factors that affect the risks of material misstatement.
3. Design the nature, timing, and extent of further audit procedures.

5-8.

The four steps involved in assessing the risk of material misstatements are:
1. Relating risk factors to potential misstatements in the financial statements. For
example, the risk associated with technological obsolescence of an entity’s products
might be directly related to a potential problem with the valuation of inventory at its
net realizable value.
2. Determine the magnitude of potential misstatements. Some misstatements may be
immaterial, such as the risk of misallocating prepaid expenses. Other misstatements,
such as this risk of failing to record a material write-down in the value of inventory
might have a significant impact on the financial statements.
3. Determine the likelihood of misstatements. This step involves evaluating the
probability of a material misstatement. The likelihood of a need for a write-down of
the value of inventory is high when market conditions for an entity’s products are
weak.
4. Determine significant inherent risks. Significant inherent risks, such as the risk of
fraud or the risk associated with complex transactions require specific audit attention.
It is important for the auditor to (1) identify these risks in audit planning, and (2)
appropriately respond to these risks when collecting evidence.

5-9.

The risk of material misstatement at the assertion level is a risk that influences only one
or a few assertions. For example, poor internal controls over the existence of inventory
will have no affect on the existence or valuation of fixed assets. Financial statement level
risks are risks that pervasively affect many financial statements accounts and assertions.

Incentives for fraudulent financial reporting could affect revenue recognition, the
completeness of liabilities and expenses, or the misclassification of expenses as assets.
5.10.

Your colleague is only partially correct. An audit client may have a history of making
sales only to customers with a good track record of ability to pay their receivables and
past experience shows that accounts receivable write-offs are rare and never material in
amounts. This has all the characteristics of a low risk assertion with a low probability of
material misstatement based on past history. However, in aggregate this may be a high
inherent risk assertion because of the subjectivity involved in the accounting estimate, but
the company has good internal controls over the granting of credit. The assertion needs
significant audit attention and the auditor is likely to perform tests of controls to obtain
evidence that internal controls over the granting of credit are strong. The client’s use of
the direct write-off method, while a departure from GAAP, may not result in a material
misstatement of the financial statements if the auditor is able to conclude that the
departure from GAAP is immaterial. Nevertheless, the auditor must reach a conclusion
that the departure from GAAP will not result in a material misstatement in the current
year.

5.11.

A significant inherent risk is a matter that, in the auditor’s judgment, requires special
audit consideration. Two examples of a significant inherent risk might be (1) an assertion
with a high risk of fraud, or (2) an assertion that has a high degree of subjectivity in
measurement.

5-12. An auditor might respond to a high risk of fraud in an assertion, by assigning more
experienced staff to that audit area. The auditor might also respond to the audit of an
assertion that involves a high degree of subjectivity by increasing the level of supervision
of staff to audit that assertion.
5-13. a.

The purpose of risk assessment procedures is to help the auditor assess the risk of
material misstatement in an assertion, whether performed early in the audit
engagement or in response to new information obtained during the audit.

b.

The purpose of tests of controls is to provide evidence about the operating
effectiveness of various aspects of the system of internal control.

c.

The purpose of substantive test is to provide evidence about the fair presentation
of management’s assertions in the financial statements.

5-14. The following discussion explains the six major types of substantive test and provides an
example of each.
1. Initial procedures that involve understanding the economic substance of the account
balance or transactions being audited and agreeing on detailed information about an
account to the general ledger. For example, the auditor might understand the
economic substance of revenue transactions and when title passes to goods or
services. The auditor should also tie out the detail of accounts receivable subsidiary
ledgers to the general ledger before sending confirmations.
2. Substantive analytic procedures involve the use of comparisons to assess the
fairness of an assertion. For example, the auditor might evaluate sales per square foot
of retail space in testing the reasonableness of revenues.

3. Tests of details of transactions involve examining documentary support for
transactions. For example, an auditor might inspect sales orders and a bill of lading
behind a recorded sales invoice.
4. Tests of details of balances involve examining support for a general ledger balance.
For example, the auditor might send confirmations to customers to obtain evidence
that they owe receivables.
5. Tests of details of accounting estimates that involve obtaining evidence in support
of the client’s estimation process and ensuring that the estimation process is applied
consistently from period to period. For example, the auditor might reperform the
process of estimating the allowance for doubtful accounts.
6. Tests of details of disclosures that involve examining support for financial statement
disclosures. For example, the auditor might read a loan contract to ascertain the
maturity schedule and debt covenants for the loan.
5.15.

The following discussion explains two different audit strategies that use a different nature
of audit test for examining the existence of inventory.
1. If the client has strong internal controls over the existence of inventory (e.g, the client
uses has a good perpetual inventory system and regularly tests the accuracy of
recorded inventory by counting inventory on hand) the auditor will perform tests of
controls to ensure that the control is operating effectively, and may then reduce the
extensiveness of inventory observation procedures.
2. If the client has weak internal controls over the existence of inventory the auditor will
likely perform extensive procedures to observe the client’s inventory at year-end.

5-16. a.

5-17.

The auditor’s decision about the timing of accounts receivable confirmations (to
test the existence of accounts receivable) relates to whether the auditor will
confirm year-end balances or send confirmations relating to the accounts
receivable balances in the general ledger one or two months prior to year-end.

b.

The auditor will usually change the timing of substantive tests, such as confirming
receivables as of October 31st for a December 31st year-end client, only if the
client has a strong system of internal control.

a.

Decisions about the extent of audit tests are decisions about sample size. For
example, with the auditor observe 50% of a client’s inventory or 90% of the
client’s inventory.

b.

The auditor should be aware of two cautions regarding sample size. First,
increasing sample size is an effective way to respond to risk only if the tests are
relevant to the specific risk. For example, sending more confirmations to
customers may not help the auditor to better assess the collectibility of
receivables, for confirmations are not relevant to the net realizable value of
receivables. Second, if the sample size is too small, there may be an unacceptable
risk that the auditor’s conclusion from the sample may be different from the
conclusion reached if the entire population were to be subjected to the same audit
procedure.

5-18. When the auditor identifies significant inherent risks in an audit, the auditor should:

1.

Evaluate the effectiveness of the design of internal controls related to all
significant inherent risks.

2.

If the auditor plans on obtaining evidence from tests of controls to mitigate a
significant inherent risk, the auditor should test the operating effectiveness of the
relevant control in the current audit period.

3.

The auditor should perform substantive tests that are responsive to significant
inherent risks.

5-19. The auditor would normally perform further risk assessment procedures in response to
evidence obtained during the audit that is inconsistent with previous risk assessments.
This evidence could come from either performing tests of controls or substantive tests.
5-20. a.

b.

The auditor will perform tests of controls when internal controls related to an
assertion appear to be strong. If they are effectively designed, the auditor will
perform tests of controls to obtain evidence that they operate effectively.
It is usually necessary to perform tests of controls when the auditor cannot reduce
audit risk to an acceptable low level by using substantive tests alone. In some
cases the client’s use of technology leave virtually not paper trail of a transaction,
such as a bank’s use of automated teller machines or an airlines use of electronic
ticketing. In these cases it is essential that the auditor test the internal controls
over these transaction streams to obtain evidence about the underlying reliability
of the client’s data.

5-21. If detection risk is assessed at a low level the auditor will normally perform:

More effective substantive tests (e.g., more competent evidence).

More extensive substantive tests.

Substantive tests at year-end.

5-22. Disagree. Auditors use the audit risk model over and over again to make decisions about
the nature, timing, extent and staffing of audit tests. At the end of the audit the auditor
needs to make sure that sufficient, competent evidence is obtained for each material
assertion in the financial statements.
5-23. The concept of effectiveness of operation of internal controls recognizes that there may
be some deviations in the way controls are applied. When deviations in internal control
are detected, the auditor needs to make inquiries and obtain evidence to understand these
deviations and their potential consequences. The more pervasive the nature of the
deviations from internal control policies, the more the auditor may need to consider
significant revisions in the audit plan.
5-24. If an auditor finds only one instance of unintentional error during the audit of an
assertion, the auditor must project that rate of error on the unsampled portion of the
population. The auditor cannot assume that it is an isolated instance, but rather the
auditor should conclude that it is representative of the balance of the population. It is
possible that the auditor can project the amount of misstatement on the balance of the
population and still conclude that the population is materially correct. Nevertheless, the

auditor must conclude that the evidence is representative of other transactions related to
the assertion that have not been audited.
5-25. The auditor’s documentation would normally include:

5-26

The overall responses to the risks of misstatement at the financial statement level.

The nature, timing, and extent of further audit procedures.

The linkage of those procedures with the assessed risk at the assertion level.

The results of the audit procedures.

The nature and effect of aggregated misstatements.

The auditor’s conclusion as to whether the aggregated misstatements cause the
financial statement to be materially misstated.

The qualitative factors the auditor considered in evaluating whether misstatements
were material and the conclusion.

The three basic categories of communication of audit findings are (1) communication
through the auditor’s report, (2) other required communications, and (3) communication
of other findings. Two examples of communicating to financial statement users through
an audit report would be issuing either an unqualified opinion or a qualified opinion on
the financial statements. Two examples of other required communication include
communications with management about known weaknesses in internal controls or about
management’s judgments and accounting estimates in the financial statements. Two
examples of other assurance services findings would be communicating the findings in a
business risk assessment engagement or in a performance measurement engagement.

Comprehensive Questions
5-27. (Estimate time – 30 minutes)
a.

The audit is not as simple as ensuring that every transaction is recorded in the
financial statements and that every recorded transaction is recorded correctly.
First, the application of generally accepted accounting principles requires
significant professional judgment. For example, determining that accounts
receivables are recorded correctly requires an estimate of the receivables that may
be uncollectible. Further, the inherent limitation of completing an audit within
economic limits does not allow the auditor to evaluate every transaction, every
receivable, or every item in inventory. Once the auditor determines that it is not
practical to evaluate every transaction, the auditor must consider a process that
guides the allocation of audit resources to the most significant audit areas. In the
end, the auditor must have sufficient competent evidence for each material
assertion in the financial statements.

b / c. An alternative audit process that guides the allocation of audit resources to the
most significant audit areas involves the following description of the audit
process. The table below identifies the phases of the audit and explains how each
phase supports an opinion on the financial statements.
Phase of the in audit
process
Phase I: Perform Risk
Assessment
Procedures
Phase II: Assess the
Risk of Material
Misstatement

Phase III: Respond to
Assessed Risks
Phase IV: Perform
Further Audit
Procedures

Phase V: Evaluate
Audit Evidence

Phase VI:
Communicate Audit
Findings

Discussion of how audit step supports an opinion
on the financial statements.
The first steps involved in performing risk assessment
procedures assist the auditor in understanding the risk
of material misstatement so that procedures can be
tailored to attend to assertions that have a high risk of
material misstatement.
The process of risk assessing the risk of material
misstatement includes relating risk factors to potential
misstatements in the financial statements, assessing
the magnitude of potential misstatements and the
likelihood of potential misstatements. These
procedures allow the auditor to focus attention on
assertions with a high likelihood of material
misstatement.
Responding to assessed risks involves planning
specific audit procedures that will help the auditor
determine if material misstatements exist in the
financial information presented for audit.
Performing further audit procedures involves
obtaining sufficient, competent evidence about
whether financial statements assertions contain
material misstatements. At this stage the auditor
might perform additional risk assessment procedures,
tests of controls, or substantive tests.
Once procedures are performed the auditor needs to
evaluate the evidence obtained to determine if the
audit process supports a conclusion that financial
statements assertions are presented fairly in all
material respect.
The auditor communicates audit findings in three
ways: (1) direct communication with financial
statement users through an audit report, (2) additional
communications of audit findings with management
and the board of directors, (3) through communicating
the findings of any other assurance services with
relevant decision makers.

d.

The primary purpose of the audit is to issue an opinion about whether the financial
statements present fairly in accordance with GAAP. The auditor also has other
responsibilities with respect to required communications with the audit committee of the
board of directors or other equivalent authority. For example, the auditor might identify
recommendations for how to improve the entity’s system of internal control. In addition,
the auditor may learn information when performing the audit such that the auditor has
recommendations that extend beyond those required by professional standards. These
recommendations often address other assurance services such as business risk assessment
or how to improve performance measures.

5-28. (Estimated time - 30 minutes)
The following discussion provides examples, in the context of sales and receivables, of
how the following steps involved in the audit process, might influence the evidence
collected to support an opinion on the financial statements:
Key Audit
Planning Step
Knowledge of the
entity and its
environment

Assertions

Describe How Audit Planning Step
Would Influence Collection of Audit Evidence
Knowledge of the entity and its environment might influence
the persuasiveness of evidence collected through analytical
procedures. In other words, it would help the auditor
determine if information such as the relationship between sales
and total assets, or the relationship between accounts receivable
and the provision for bad debts are consistent with expectations
developed from independent knowledge of the industry.
Knowledge of the entity and its environment may also influence
the amount and type of evidence needed to evaluate accounting
estimates such as bad debt expense. If independent knowledge
of the industry shows that trade terms normally result in
collection periods of 90 to 120 days, this will influence the
auditor’s evaluation of when accounts should be considered
uncollectible.
Management’s financial statement assertions guide the auditor
in the collection of evidence in the audit process. Each
assertion requires different types of evidence. In forming an
opinion on the financial statements taken as a whole, the auditor
divides and conquers the entire audit by obtaining evidence for
each of management’s assertions related to each material
account balance and transaction class. For example, the
evidence that support the conclusion that revenue has been
properly recognized (existence and occurrence) will not support
the conclusion that all sales are recorded (completeness).

Key Audit
Planning Step
Materiality

Analytical
procedures

Assess the risk of
material
misstatement,
including the risk of
fraud

Develop preliminary
audit strategies

Describe How Audit Planning Step
Would Influence Collection of Audit Evidence
Decisions about materiality help the auditor determine the items
in the financial statements that are significant and those that are
not. The auditor will collect less evidence about the receivables
that are less material. The more material a receivable, the more
important it is to obtain evidence about that receivable to
support an opinion on the financial statements.
The auditor performs analytical procedures to compare
unaudited data with the auditor’s expectations about the data. If
the auditor expect that it should take about 30 days to collect
receivables, but unaudited receivable turn days is 45, it is
possible that receivables are overstated due to revenue
recognition problems or that there are valuation problems with
receivables that have not been written off.
The audit risk model influences the collection of evidence in
several ways. For example, the auditor may assess control risk
for occurrence of sales at the maximum due to the problems
associated with revenue recognition. If internal controls over
revenue recognition are strong, the auditor needs to perform
tests of controls to obtain evidence that specific controls over
revenue recognition are effectively designed and that they
operate effectively.
Second, the auditor’s decisions about overall audit risk, inherent
risk and control risk influence detection risk. A low risk
assessment for detection risk implies that there can only be a
low risk that substantive tests will fail to detect material
misstatements in an assertion. As a result the auditor should
increase either the amount of evidence supporting the
appropriateness of revenue recognition, or the effectiveness of
audit procedures that support a conclusion about revenue
recognition so that evidence supports the assessment of
detection risk as low.
Auditors often make preliminary decisions about the
components of the audit risk model and develop preliminary
strategies for the collection of evidence. In a recurring audit,
the auditor begins the audit with previous experience with the
entity. After performing risk assessment procedures the auditor
might chose to emphasize tests of controls for one assertion or
substantive tests for another. Preliminary strategies guide the
collection of evidence.

Key Audit
Planning Step
Understand the
entity’s internal
control.

5-29.

Describe How Audit Planning Step
Would Influence Collection of Audit Evidence
The auditor uses the understand of internal control to:
1. Identify types of potential misstatements.
2. Consider factors that affect the risks of material
misstatement.
3. Design the nature, timing, and extent of further audit
procedures.
Knowledge of internal control assists the auditor in designing
effective audit strategies.

(Estimated time - 15 minutes)
Audit Objective
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.

5-30.

Assertion
Valuation or allocation
Existence or occurrence
Completeness
Presentation and disclosure
Rights and obligations
Presentation and disclosure
Completeness
Rights and obligations
Valuation or allocation
Valuation or allocation
Presentation and disclosure

(Estimated time - 15 minutes)
Audit Objective
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.

Assertion
Valuation or allocation
Completeness
Existence and occurrence
Completeness
Rights and obligations
Completeness
Valuation and allocation
Existence and occurrence
Presentation and disclosures
Valuation or allocation
Presentation and disclosure

5-31. (Estimated time – 20 minutes)
a.

Understanding an entity’s industry, regulatory environment, and other factors sets
the context for developing an expectation of the client’s financial statements. For
example, if regulation by a foreign country results in banning the import of the
client’s product, and the client has had significant exports to that company, the
auditor should expect a decline in profitability associated with the challenges of
find for products that cannot be exported.

b.

Understanding the nature of the entity also sets an important context for the
assessing the risk of material misstatement. For example, if a client has a number
of long-term construction contracts, the auditor should be aware of the estimation
that is involved in recognizing revenue associated with the long-term contracts.
The degree of subjectivity associated with the existence and occurrence assertion
increases the risk of material misstatement in the assertion.

c.

Understanding the entity’ objectives, strategies, and related business are important
because the risk of material misstatement is often associated the financial
consequences of an entity’s business risk. For example, if a pharmaceutical
company is unable to obtain FDA approval for a new drug there is a significant
risk associated with the impairment of development costs that may have been
capitalized.

d.

Understanding how an entity manages and reviews its financial performance my
provide clues about the risk of material misstatements. For example, the pressure
to engage in inappropriate earnings management may be increased when the
client uses performance-based bonuses or incentive compensation packages based
on sales or earnings.

5-32. (Estimated time - 20 minutes)
a.

Two types of circumstances, in addition to departures from facts that may cause
financial statements to be misstated are (1) misapplications of GAAP and (2)
omissions of necessary information.

b.

In planning the audit, materiality should be assessed at the following two levels for
the reasons indicated:
 The financial statement level because the auditor's opinion on fairness extends
to the financial statements taken as a whole.
 The account balance level because the auditor verifies account balances in
reaching an overall conclusion on the fairness of the financial statements.

c.

When planning materiality is determined in July for a calendar year-end audit
client, the materiality judgments may be based on annualizing available interim
data for the first six months. Alternatively, they may be premised on one or more
prior years' financial results adjusted for current changes such as the general
condition of the economy and industry trends.

5-33.

d.

The size of an account balance generally represents an upper limit on the amount
by which an account can be overstated. However, the size of a recorded balance
does not establish any limit on the amount by which an account can be understated.

e.

The term material account balance refers to the size of a recorded account balance.
The term materiality refers to the amount of misstatement that could affect a user's
decision. Generally, there is a direct relationship between the size of an account
balance and the amount of evidence needed for assertions related to the account. In
contrast, there is an inverse relationship between materiality and the amount of
evidence needed. That is, the smaller materiality, the more evidence that is needed
to obtain reasonable assurance that misstatements do not exceed that level.

(Estimated time - 25 minutes)
a.

Audit risk is the risk that the auditor may unknowingly fail to appropriately modify
the auditor's opinion on financial statements that are materially misstated.
Inherent risk is the susceptibility of an assertion to a material misstatement,
assuming that there are no related internal control structure policies or procedures.
Control risk is the risk that a material misstatement that could occur in an assertion
will not be prevented or detected on a timely basis by the entity's internal control
structure policies or procedures.
Detection risk is the risk that the auditor will not detect a material misstatement
that exists in an assertion.

b.

The form of the audit risk model used for solving for detection risk is:
DR  AR /( IR  CR )

Situation A
B
C
D
E
F
G

=
=
=
=
=
=
=

.01/
.01/
.05/
.05/
.05/
.05/
.10/

(.20  .50)
(1.00 x .07)
(.20  .50)
(.50  .40)
(1.00 x .07)
(1.00 x .80)
(.50  .20)

=
=
=
=
=
=
=

* In situation G, the assessed levels of inherent and control risk are sufficiently
low that the desired audit risk is achieved without restricting detection risk.
Thus, for these situations it may not be necessary to perform substantive tests
to obtain evidence the assertion.

.10
.14
.50
.25
.71
.06
1.00 *

c.

The rankings from most evidence required to least are:
Situation
Ranking

A
2

B
3

C
5

D
4

E
6

F
1

G
7

F
1

A
2

B
3

D
4

C
5

E
6

G
7

Or
Situation
Ranking

Note that more evidence is associated with lower levels of detection risk.

5-34.

d.

In situation E the detection risk is relatively high (although inherent risk is high –
100%; control risk is assessed at a relatively low level – 7%). Therefore the
auditor may be able to restrict their substantive tests. In situation F the detection
risk is very low, 6%, which will necessitate more effective substantive tests,
performed at year-end and larger sample sizes.

e.

The indicated changes would have the following effects on planned detection risk
for each situation:
1. Increase planned detection risk.
2. Increase planned detection risk.
3. Decrease planned detection risk.

(Estimated Time - 15 minutes)
a.

The most likely assertions that may be misstated in the revenue cycle are the
valuation and allocation assertion and the existence and occurrence assertion. The
statement that some customers are having financial difficulties because of slowing
demand for the client’s product focuses the problem of an inadequate allowance
for doubtful accounts (valuation and allocation). If demand is slowing, and the
client is attempts to make up for slowing demand by significant price concessions
or channel stuffing the auditor should also be concerned about revenue
recognition problems (existence and occurrence). Either misstatement results in
an overstatement of receivables and profits.

b.

In the context of inventory the auditor should consider that the valuation of
inventory at its net realizable value is a significant risk. The client has slow
moving inventory that has a technological obsolescence problem. This
misstatement would result in an overstatement of inventory and an understatement
of cost of sales.

5-35. (Estimated time - 30 minutes)
Case 1. (Strong internal controls over physical inventory)
b.

Existence and occurrence of inventory

c.

Yes. Significant resources are tied up in the existence of inventory of a highly
technical nature. Failure to correctly state the existence of inventory will have a
significant impact on gross margin.

d.

The auditor should assign staff that is familiar with the industry and have the
skills to identify (1) what specific items in inventory area and (2) slow moving or
obsolete products.

e.

The auditor will likely emphasize tests of controls because internal controls
appear to be strong.

f.

Tests of controls will likely be preformed at an interim date. If tests of controls
confirm that internal controls are strong, the auditor might also observe inventory
on or two months prior to year-end.

g.

If tests of controls confirm that internal controls are strong, the auditor can reduce
the extent of substantive tests of related to the observation of inventory.

Case 2: (Rapid price declines for flat panel televisions)
a.

Valuation of inventory

b.

Yes. There is a significant inherent risk that inventory could be valued at cost
which could be higher than its net realizable value.

c.

Staff should be assigned to the audit of the net realizable value of inventory
should have some experience in the industry. It is important not only to
recognize subsequent sales information, but also the auditor must determine if the
proper items have been included in the calculation of manufacturing cost.

d.

The nature of tests will focus on substantive tests of net realizable value. There is
not evidence that internal controls over this accounting estimate are strong.

e.

The timing of tests will usually happen after year-end (focused on the year-end
balance0, to take into account subsequent information about the sale of inventory
on hand at year-end.

f.

The extent of tests will be extensive and test a representative sample of the
population of flat panel television models in inventory.

Case 3: (General Television paid a significant premium in the acquisition of Micro Engineering).
a.

The valuation of goodwill.

b.

Yes, there appears to be significant risk that goodwill could be impaired as the flat
panel television business is not generating the level of cash flows that may have
been expected now that the market has become highly competitive.

c.

The impairment for goodwill requires significant experience in understanding
mergers and the valuation of company segments.

d.

The nature of the audit tests should focus on direct substantive tests of the
valuation assertion and the possible impairment of goodwill.

e.

The timing of the test of the accounting estimate will usually focus on the yearend balance and will often happen after year-end to consider all subsequent
information that may be available about the underlying value of the acquired
company.

f.

Tests of the accounting estimate focused on the impairment of goodwill will be
extensive and the auditor may often reperform the client’s estimation process.

5-36. (Estimated time – 45 minutes)
Category of Audit
Procedures
Further risk
assessment
procedures
Tests of controls
Initial procedures

Analytical procedures

Tests of details of
transactions
Tests of details of
balances
Tests of details of
accounting estimates
Tests of details of
disclosures

Example in the Context of Auditing
Inventory
When observing inventory the auditor might
find that internal controls over the existence of
inventory were not as effective as previously
expected.
The auditor might find that controls over the
valuation of inventory at its historical cost are
working effectively.
Initial procedures focus on understanding the
underlying economic substance of the
underlying inventory. They also focus on
obtaining a detail listing of inventory where the
sum of the values agrees to the general ledger.
If the value of inventory is growing faster than
sales, and inventory turn days are increasing,
the auditor might expect that inventory could
be overstated due to either existence and
occurrence problems or valuation problems.
The auditor might test transactions associated
with the purchase of raw materials or
conversion costs as part of testing the valuation
of inventory.
The auditor should physically observe the
inventory on hand as part of testing the
existence and occurrence assertion.
The auditor might compare inventory costs to
subsequent sale prices as part of testing the net
realizable value of inventory.
The auditor might recalculate a LIFO reserve
that is disclosed in the notes to the financial
statements.

How would the Procedure
Relate to an Element of
the Audit Risk Model?
Control risk

Control risk
Detection risk

Detection risk

Detection risk

Detection risk
Detection risk
Detection risk

5-37. (Estimated time – 20 minutes)
a.

Following is an analysis of the transactions marked 1, 2 and 3.
1.

There is no misstatement in this transaction. The goods were received,
and title passed to the buyer, in January of X5 and recorded in X5 in the
proper amount.

b.

2.

Title passed to this shipment on 12/27/X4, yet the shipment was not
recorded until X5. This is a completeness problem in the amount of
$100,000. The transaction was not recorded.

3.

There is no misstatement relative to 20x4. However, the voucher has
under priced the payable by $2 per unit or $7,000. This is a problem for
20X5 that should be communicated to the client.

The net effect of these transactions is that accounts payable are understated by
$100,000 out of a sample of $1 million. The projected error represents a likely
misstatement where accounts payable of $4 million is understated by $400,000
($100,000 / $1,000,000 x $4,000,000).

5-38. (Estimated time – 10 minutes)
a.

During the financial statement audit the auditor learns more about the client than
merely whether the financial statements are presented fairly in accordance with
GAAP. For example, when performing analytical procedures the auditor might
identify that the client is performing poorly compared to its industry competitors.
The auditor’s industry experience might also allow the auditor to make
recommendations on how to be more competitive. The auditor might also gain an
understanding of the underlying economic drivers that the auditor’s assessment of
the financial consequences of the entity’s business risks. This will allow the
auditor to comment on the entity’s ability to measure and monitor its business
risks.

b.

In order to serve the public by providing an opinion on the financial statements,
the auditor needs to be independent of management and the entity. It is important
that the auditor remain in an advisory capacity and that management and the
board of directors actually take responsibility for management decisions and that
management take responsibility for the implementation of recommendations.
Further, auditors of public companies are prevented from providing the following
services:








Bookkeeping or other services related to the accounting records or financial
statements of the audit client.
Financial information systems design and implementation.
Appraisal or valuation services, fairness opinions, or contribution-in-kind
reports.
Actuarial services.
Internal audit outsourcing services.
Management functions or human resources.
Broker or dealer, investment advisor, or investment banking services.
Legal services and expert services unrelated to the audit.
Any other service that the PCAOB determines, by regulation, is
impermissible.

Research
Situation

Draft
Report

AU 316.14-18 addresses the issue of the required discussion among engagement personnel
regarding the risk of material misstatement due to fraud. The direct quote, cut from the
professional standards is quoted below.
“Discussion Among Engagement Personnel Regarding the Risks of Material Misstatement Due
to Fraud
.14
Prior to or in conjunction with the information-gathering procedures described in
paragraphs .19 through .34 of this section, members of the audit team should discuss the
potential for material misstatement due to fraud. The discussion should include:

An exchange of ideas or "brainstorming" among the audit team members, including the
auditor with final responsibility for the audit, about how and where they believe the
entity's financial statements might be susceptible to material misstatement due to fraud,
how management could perpetrate and conceal fraudulent financial reporting, and how
assets of the entity could be misappropriated. (See paragraph .15.)
An emphasis on the importance of maintaining the proper state of mind throughout the
audit regarding the potential for material misstatement due to fraud. (See paragraph .16.)

.15
The discussion among the audit team members about the susceptibility of the entity's
financial statements to material misstatement due to fraud should include a consideration of the
known external and internal factors affecting the entity that might (a) create incentives/pressures
for management and others to commit fraud, (b) provide the opportunity for fraud to be
perpetrated, and (c) indicate a culture or environment that enables management to rationalize
committing fraud. The discussion should occur with an attitude that includes a questioning mind
as described in paragraph .16 and, for this purpose, setting aside any prior beliefs the audit team
members may have that management is honest and has integrity. In this regard, the discussion
should include a consideration of the risk of management override of controls. fn 8 Finally, the
discussion should include how the auditor might respond to the susceptibility of the entity's
financial statements to material misstatement due to fraud.
.16
The discussion among the audit team members should emphasize the need to maintain a
questioning mind and to exercise professional skepticism in gathering and evaluating evidence
throughout the audit, as described in paragraph .13. This should lead the audit team members to
continually be alert for information or other conditions (such as those presented in paragraph .68)
that indicate a material misstatement due to fraud may have occurred. It should also lead audit
team members to thoroughly probe the issues, acquire additional evidence as necessary, and
consult with other team members and, if appropriate, experts in the firm, rather than rationalize
or dismiss information or other conditions that indicate a material misstatement due to fraud may
have occurred.

.17
Although professional judgment should be used in determining which audit team
members should be included in the discussion, the discussion ordinarily should involve the key
members of the audit team. A number of factors will influence the extent of the discussion and
how it should occur. For example, if the audit involves more than one location, there could be
multiple discussions with team members in differing locations. Another factor to consider in
planning the discussions is whether to include specialists assigned to the audit team. For
example, if the auditor has determined that a professional possessing information technology
skills is needed on the audit team (see section 319.32), it may be useful to include that individual
in the discussion.
.18
Communication among the audit team members about the risks of material misstatement
due to fraud also should continue throughout the audit—for example, in evaluating the risks of
material misstatement due to fraud at or near the completion of the field work. (See paragraph .
74 and footnote 28.)”

Draft
Report
Situation

Research

A proposed memo address the questions associated with the portion of the problem is provided
below along with relevant references to Statements on Auditing Standards.
To:
Michelle Driscoll
Re:
Fraud Risk Factors
From: CPA Candidate
AU 316, Consideration of Fraud in a Financial Statement Audit, provides professional guidance
regarding the auditor’s responsibility for considering fraud in the financial statement audit.
Guidance regarding the auditor’s responsibility to identify fraud risk factors is covered in AU
316.20-.34. In summary, the auditor should gather information necessary to identify risks of
material misstatement due to fraud, by
 Inquiring of management and others within the entity about the risks of fraud. (See
paragraphs .20 through .27.)
 Considering the results of the analytical procedures performed in planning the audit. (See
paragraphs .28 through .30.)
 Considering fraud risk factors. (See paragraphs .31 through .33, and the Appendix,
"Examples of Fraud Risk Factors" [paragraph .85].)
 Considering certain other information. (See paragraph .34.)
The appendix with example fraud risk factors provides the following examples of fraud risk
factors related to fraudulent financial reporting.

Incentives/Pressures
a. Financial stability or profitability is threatened by economic, industry, or entity operating
conditions, such as (or as indicated by):
 High degree of competition or market saturation, accompanied by declining margins
 High vulnerability to rapid changes, such as changes in technology, product
obsolescence, or interest rates
b. Excessive pressure exists for management to meet the requirements or expectations of
third parties due to the following:
 Profitability or trend level expectations of investment analysts, institutional investors,
significant creditors, or other external parties (particularly expectations that are
unduly aggressive or unrealistic), including expectations created by management in,
for example, overly optimistic press releases or annual report messages
 Need to obtain additional debt or equity financing to stay competitive—including
financing of major research and development or capital expenditures
 Marginal ability to meet exchange listing requirements or debt repayment or other
debt covenant requirements
c. Information available indicates that management or the board of directors' personal
financial situation is threatened by the entity's financial performance arising from the
following:
 Significant financial interests in the entity
 Significant portions of their compensation (for example, bonuses, stock options, and
earn-out arrangements) being contingent upon achieving aggressive targets for stock
price, operating results, financial position, or cash flow fn 1
d. There is excessive pressure on management or operating personnel to meet financial
targets set up by the board of directors or management, including sales or profitability
incentive goals.
Opportunities
a. The nature of the industry or the entity's operations provides opportunities to engage in
fraudulent financial reporting that can arise from the following:
 Significant related-party transactions not in the ordinary course of business or with
related entities not audited or audited by another firm
 A strong financial presence or ability to dominate a certain industry sector that allows
the entity to dictate terms or conditions to suppliers or customers that may result in
inappropriate or non-arm's-length transactions
b. There is ineffective monitoring of management as a result of the following:
 Domination of management by a single person or small group (in a nonownermanaged business) without compensating controls
 Ineffective board of directors or audit committee oversight over the financial
reporting process and internal control
c. There is a complex or unstable organizational structure, as evidenced by the following:

Difficulty in determining the organization or individuals that have controlling interest
in the entity
 Overly complex organizational structure involving unusual legal entities or
managerial lines of authority
d. Internal control components are deficient as a result of the following:
 Inadequate monitoring of controls, including automated controls and controls over
interim financial reporting (where external reporting is required)
 High turnover rates or employment of ineffective accounting, internal audit, or
information technology staff
Attitudes/Rationalizations
Risk factors reflective of attitudes/rationalizations by board members, management, or
employees, that allow them to engage in and/or justify fraudulent financial reporting, may
not be susceptible to observation by the auditor. Nevertheless, the auditor who becomes
aware of the existence of such information should consider it in identifying the risks of
material misstatement arising from fraudulent financial reporting. For example, auditors may
become aware of the following information that may indicate a risk factor:
 Ineffective communication, implementation, support, or enforcement of the entity's
values or ethical standards by management or the communication of inappropriate
values or ethical standards
 Nonfinancial management's excessive participation in or preoccupation with the
selection of accounting principles or the determination of significant estimates
 Known history of violations of securities laws or other laws and regulations, or claims
against the entity, its senior management, or board members alleging fraud or
violations of laws and regulations
 Excessive interest by management in maintaining or increasing the entity's stock price
or earnings trend
Finally, AU 316.83 provides the following guidance regarding documentation that should be
included in the audit working papers. The auditor should document the following:
 The discussion among engagement personnel in planning the audit regarding the
susceptibility of the entity's financial statements to material misstatement due to fraud,
including how and when the discussion occurred, the audit team members who
participated, and the subject matter discussed (See paragraphs .14 through .17.)

The procedures performed to obtain information necessary to identify and assess the risks
of material misstatement due to fraud (See paragraphs .19 through .34.)

Specific risks of material misstatement due to fraud that were identified (see paragraphs .
35 through .45), and a description of the auditor's response to those risks (See
paragraphs .46 through .56.)

If the auditor has not identified in a particular circumstance, improper revenue
recognition as a risk of material misstatement due to fraud, the reasons supporting the
auditor's conclusion (See paragraph .41.)

The results of the procedures performed to further address the risk of management
override of controls (See paragraphs .58 through .67.)

Other conditions and analytical relationships that caused the auditor to believe that
additional auditing procedures or other responses were required and any further responses
the auditor concluded were appropriate, to address such risks or other conditions (See
paragraphs .68 through .73.)

The nature of the communications about fraud made to management, the audit
committee, and others (See paragraphs .79 through .82.)