UNIT I OVERVIEW OF THE CORE CONCEPTS OF FINANCIAL STATEMENTS AUDIT Chapter 1 Core Concepts of a Risk-Based Approach to Conducting a Quality AuditChapter CORE CONCEPTS OF A RISK-BASED APPROACH TO CONDUCTING A QUALITY AUDIT Expected Learning Outcomes After studying this chapter, you should be able to: 1. Understand the core concepts of a Financial Statement Audit including the following: © — Nature of an independent Financial Statement Audit © The overall objectives of the Independent Auditor and the: conduct of an audit in accordance with Philippine Standards on Auditing. * Ethical Requirements Relating to an Audit of Financial Statements. Conduet of an Audit of Financial Statements. Scope of an Audit of Financial Audit. Professional Skepticism. Reasonable Assurance. Audit risk and Maleriafity, Responsibility for the Financial Statements Understand the Risk-Based Audit Process © Distinction between risk-based audit approach and account- based activities . Stages and the activities in the risk-based audit process Relevant Philippine Standards on Auditing {PSAs) used in the Rik Based AN Eee rink © Components of the -Risk Model . Factors to consider in Implementing the Audil Risk Model Limitations of the Audit Risk Model BSBCHAPTER 1 CONCEPTS OF A RISK-BASED APPROACR ConR TO CONDUCTING A QUALITY AUDIT NATURE OF INDEPENDENT FINANCIAL STATEMENTS AUDIT ing is a systematic process by which a competent. independent pe ny obtains and evaluates evidence regarding assertions about econge actions and events to ascertain the degree of correspondence between those assertions and established criteria and communicating the results to interesteg users. OVERALL OBJECTIVES OF THE INDEPENDENT AUDITOR ANp THE CONDUCT OF AN AUDIT IN ACCORDANCE WITH PHILIPPINE STANDARDS ON AUDITING (PSB200) The Philippine Standard on Auditing (PSA) establishes the independent auditors overall responsibilities when conducting an audit of financial s1 Specifically, it sets out the overall objectives of the independent auditor, explains the nature and scope of an audit designed to cnable the independent auditor 10 meet those objectives. It also explains the scope, authority and structure of the PSAs. and includes requirements establishing the general responsi of the independent auditor applicable in all audits, including the obligation to comply with the PSAs. OBJECTIVES OF AN AUDIT In conducting an audit of financial statements, the overall objectives of the auditor are: (a) To obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due 10 fraud.or error, them by enabling the auditor to express an opinion on whether the financial statements are prepared, in all material respects, in accordance with an applicable financial feporting framework: and (b) To report on the financial statements, and communicate as required by the PSAs, in accordance with the auditor's findings._ A RishelRased Approach tu Cenuctiny: & Qual Audit _ 3 The purpose of an audi s to enhance the degree of confidence of intended users in the financint statements. ‘This is achieved by the expression of an opinion by the auditor on whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework. In the case of most general-purpose frameworks, that opinion is on whether the financial stalements are presented fairly, in all material respects, in accordance with the framework. An audit conducted in accordance with PSAs and relevant ethical requirements enables the auditor to form that opinion. An audit of financial statements is an assurance engagement, as defined in the Philippine Framework for Assurance Engagements. The Framework defines and describes the elements and objectives of an assurance engagement. The PSAs apply the Framework in the context of an audit of financial statements and contain the basic principles and cssential procedures, together with related guidance, to be applied in such an audit. ETHICAL REQUIREMENTS RELATING TO AN AUDIT OF FINANCIAL STATEMENTS The auditor should comply with relevant cthical requirements relating to audit engagements. As discussed in PSA 220, "Quality Control for an Audits of Financial Statements,” ethical requirements relating to audits of financial statements ordinarily comprise Parts A and B of the Code of Ethics for Professional Accountants in the Philippines (Ethics Code)' effective April 6, 2018 adopted and promulgated by the Board uf Accountancy. PSA 220 (Revised) identifies the fundamental principles of professional ethics established by Parts A and B of the Ethics Code and sets out the engagement partner's responsibilities with respect to ethical requirements. PSA 220 recognizes that the engagement team is entitled to rely on a firm's systems in meeting its responsibilitics with respect to quality control procedures applicable to the individual audit engagement (for example, in relation to capabilities and competence of personnel through their recruitment and formal training; independence through the accumulation and communication of relevant independence information; maintenance of client relationships through acceptance and’ continuance systems; and adherence to regulatory and legal requirements through the monitoring process), unless information provided by the firm or other parties suggests otherwise. Accordingly, Philippine Standard on Quality Control (PSQC) 1, "Quality Control for Firms that Perform Audits and ‘Adepied 10 the Code of Ethics for Profersional Accountants issued by the International Federation of Accomants —*4c ort Reviews of Financial Statements, and Other Assurance and Related Services Engagements," requires the firm to establish policies and procedures designed to provide it with reasonable assurance that the firm and its personnel comply with relevant ethical requirements. CONDUCT OF AN AUDIT OF FINANCIAL STATEMENTS The auditor should conduct an audit in accordance with Philippine Standards on, Auditing. . PSAs contain basic principles and essential procedures together with related guidance in the form of explanatory and other material, including appendices, The basic principles and essential procedures are to be understood and applied in the context of explanatory and other materials that provide guidance for their application. The text of a whole Standard is considered in order to understand and apply the basic principles and essential procedures. In conducting an audit in accordance with PSAs, the auditor is also aware of and considers ine Auditing Practice Statements (PAPSs) applicable to the audit engagement. PAPSs provide interpretative guidance and practical assistance to auditors in implementing PSAs. An auditor who does not apply the guidance included in a relevant PAPS needs to be prepared to explain how the basic principles and essential procedures in the Standard addressed by the PAPS have been complied with. The auditor may also conduct the audit in accordance with both ISAs and PSAs. However, there are currently no fundamental differences between the IAASB pronouncements and corresponding requirements issued by the AASC and no such differences are expected in the future,” SCOPE OF AN AUDIT OF FINANCIAL STATEMENTS The term "scope of an audit" refers to the audit procedures deemed necessary in the circumstances to achieve the objective of the audit. In determining the audit procedures to be performed in conducting an audit in accordance with Ph Standards on Auditing, the auditor should comply with each of the Philippine Standards on Auditing relevant to the audit. malin Tis Pri to the Pippa Senki (rcbar Coal Ande Review nd ihe Avarance nl tel Tp ctl te Pcs he onlin v0 nse Server th sate oof thr HES mak te rnd Sears nd Pras Ske aed 9 the epplohle anda ad prt wtement the Php a amphetnsechy hA maker ere “Fete pcm ota ans Suto and Pre See ta or ined i viermewsat canon otek rot ay ic th Pr a abel cacisnecagaptcer tccare henner seoenay oc a ket ee thr arp ShreeA Risk-Bated Approach to Conducting a Quali: Audit S The auditor should not represent compliance with Philippine Standanis on. Auditing unless the auditor has complied fully with all of the Philippine Standards on Auditing relevant to the audit, The auditor may, in exceptional Circumstances, judge it necessary to depart from a basic principle or an essential procedure that is relevant in the circumstances of the audit. in order to achieve the objective of the audit. In such 2 case, the auditor is not precluded from representing compliance with PSAs, provided the deparwre is appropriatcly documented as required by PSA 230 (Clarified), “Audit Documentation.” PROFESSIONAL SKEPTICISM The auditor should plan and perform an audit with an artitude of professional skepticism recognizing that circumstances may exist that cause the financial statements to be materially misstated. An attitude of professional skepticism means the auditor makes a critical assessment, with a questioning mind. of the validity of audit evidence obtained is alert to audit evidence that contradicts or brings into question the lity of documents and responses to inquiries and other information obtained from management and those charged with governance. For example, an attitude of professional skepticism is necessary throughout the audit process for the auditor to reduce the risk of overlooking unusual circumstances, of over generalizing when drawing conclusions from audit observations. and of using faulty assumptions in determining the nature, timing and extent of the audit procedures and evaluating the results thereof. When making inquiries and performing other audit procedures, the auditor is not satisfied with less-than- persuasive audit evidence based on a belief thar management and those charged with governance are honest and have integrity. Accordingly, representations from management are not a substitute for obtaining sufficient appropriate audit evidence to be able to draw reasonable conclusions on which to base the auditor's: opinion. REASONABLE ASSURANCE ‘An auditor conducting an audit in accordance with PSAs obtains reasonable assurance that the financial statements taken as a whole are free from material misstatement, whether due to fraud or error. Reasonable assurance is a concept relating to the accumulation of the audit evidence necessary for the auditor to conclude that there are no material misstatements in the financial statements taken as a whole. Reasonable assurance relates to the whole audit process.An for cannot obtain absolute assurance because there are inherem limitations in an ai d that affect the auditor's ability to detect’ mai misstatements. These limitations result from factors such as the following: * The use of testing. © The inherent limitations of intemal control (for exampk, the Possibility of management override or collusion), © Mhe fact that most audit evidence is persuasive rather than conclusive, Also, the work undertaken by the auditor to form an opinion is permeated by judgment, in particular regarding: (a) The gathering of audit evidence, for example, in deciding the timing and extent of audit procedure; and e mete maa (b) The drawing of conclusions based on the audit evidence gathered, for example, assessing the reasonableness of the estimates made by management in preparing the financial statements. Further, other limitations may affect the persuasiveness of evidence available to draw conclusions on particular assertions (for example, transactions. between related parties). In these cases, certain PSAs identify specified audit procedures. which will, because of the nature of the particular assertions, provide sufficient appropriate audit evidence in the absence of: (a) Unusual circumstances which increase the risk of material misstatemeat beyond that which would ordinarily be expected; or (b) Any indication that a material misstatement has occurred. Accordingly, because of the factors described above, an audit is not a guarantee that the financial statements are free from material misstatement, becaus absolute assurance is not attainable. Further, an audit opinion does not assure the future viability of the entity nor the efficiency or effectiveness with which management as conducted the affairs of the entity.— A Risk-Based Approach to Conducting a Quality Audis 7 AUDIT RISK AND MATERIALITY ine auditor obtains and evaluates audit evidence to obtain reasonable assurance about whether the financial statements give.a true and fair view or are presented fairly, in all material respects, in accordance with the applicable financial reporting framework. The concept of reasonable assurance arknowledges that there is a Fisk the audit opinion is inappropriate. The risk that the auditor expresses an inappropriate audit opi when the financial statements are materially misstated is known as “audit risk”. The auditor should plan ‘and perform the audit to reduce audit risk to an acceptably low level that is consistent with the objective of an audit. The auditor reduces audit risk by designing and performing audit procedures to obtain sufficient appropriate audit evidence to be able to draw reasonable conclusions on which to base an audit opinion. Reasonable assurance is obtained when the auditor has reduced audit risk to an acceptably low level. RESPONSIBILITY FOR THE FINANCIAL STATEMENTS While the auditor is responsible for forming and expressing an opinion on the financial statements, the responsibility for the preparation and presentation of the financial statements in accordance yith the applicable financial reporting, framework is that of the management’ of the entity, with oversight from those charged with governance. The audit of the financial statements does not relieve management or those charged with governance of their responsibilities.ac J THE RISK-BASED AUDIT PROCESS Introduction Risk-based audit approach is an audit approach that begins with an of the types and likelihood of misstatements in account balance and then adjusts the amount and type of audit tot i ial mi: scsuivlig ta scious tat Work, to the likelihood of material misstatements In risk-based audit, the-audit team views all activities in the zai i terms of risks to strategies and objectives, and then in inne oF tomemees ae plans and Processes to mitigate the risk. The auditors obtain an understanding of the client's objectives. The risks are identified and the auditors determine how management plans to mitigate the risk and whether those plans are in place and operating effectively. Account-based audits an approach wherein the auditor obtsins an understanding of control and assesses control risk for partidular types of errors and frauds in specific accounts and cycle, STAGES OF THE RISK-BASED AUDIT PROCESS Under the PSAs which are risk-based, specific audit procedures vary from one engagement to the next. The following stages are, however, involved in every engagement. Phase I. Risk Assessment This phase involves the following activities: a. Performance of preliminary engagement activities to decide whether w accept / continue an audit engagement. , : b. Planning the audit to develop an overall audit strategy and audit en ie c, Performance of risk assessment procedures to identify / assess 2 material misstatement through understanding the entity.-Buved Approach to Cumducting a (duality Audit 9 Phase I. I Risk Response This phase covers the following activities: a. Designing overall responses and further audit procedures to develop appropriate responses to the assessed risk of material misstatement, b. Implementing responses to assessed risk of matcrial misstatement to reduce audit risk to an acceptably low level. Phase ITl. Reporting This phase involves the following activities: a. Evaluating the audit evidence obtained to determine what additional audit work (if any’ ) is required. b. Forming an opinion based on audit findings and preparing the auditor's report. A simpler way of describing the three elements is illustrated below. Figure 1-1: Describing the Three Elements * An “event” is simply a business or fraud risk factor that, if it actually occurred, would adversely affect the entity's ability to achieve its objective of preparing financial statements that do not contain material misstatements resulting from error and fraud. This would also include risks resulting from the absence of internal control to mitigate the potential for material misstatements in the financial statements. Figure 1-2 shows the schematic risk-based audit process in accordance with the guidelines provided by the International Federation of Accountants,1 thay Figure 1-2: Risk-Based Audie Pr osicey* coe “y { * Tike tas Wile dione, Engpaqone ot © Adapted from “Guede t0 Using international Stondards of Aushiing 1s the Audis of Small and Medum Sued Entnes” Vokumes J and-tl, Core Coacepes | Practical Application - Fourth Edition” Copyright © November HIB by IFAC, All igherreterved. Used with permission of IFAC, ;_A Risk-Based Approach (Mealy Amite Figure 1-3 presents the Relevant Philippine Stundards On Auditing (PSAS) To Be Used In The Risk-Based Audit Process Figure L-3: Relevant Philippine Standards On Auditing (PSAS) To Me Used Ia The Risk-Based Audit Process GUIDANCE ON FUNDAMENTAL CONCEPTS. ‘Misstatement through Understanding the Enlaly and tts Environment (Newly Revised Standard offactive for audits of Sais anne by pet eoooe a ete 15, PSA 230, Audi Documentation PHASE |- RISK ASSESSMENT INCLUDING MAKING CLIENT ACCEPTANCE AND CONTINUANCE DECISIONS ‘ee Continuance Considering Fraud PSA 240, The Auditor's Responsibildies Relating to Fraud in an Audit of Financial Statements Fs Consideration of Laws and PSA 250, Consideration of Laws and Regulations in an Aucit of Regulations in Ptanning —_| Financial Statements the Audit PSA 300, P q an Audi! of Financial Stalaments ‘Assessing Risk of Material Misstalements[ee PSA 550, Related Parties PSA 540, Auditing Accounting Estimates, Including Fair Value lecounting Estimates, and relate Disclosures___A Risk-Based Approach to Conducting a Quality Audit__13 ‘Analytical Procedures asa | PSA 520, Analytical Procedures __Substantive Test _ Using an Auditors Specialist’ | PSA 620, Using the Work of an Auditor's Expert | Expert PHASE lll REPORTING Evaluating the Implications PSA 250, ‘Consideration of Laws and Regulation in an Audit of PSA 700, Forming an Opinicn and Reporting on Financial Stalements PSA 705, Meoicatons lo he Opinion in the Independent Sarit Coa Bialscuthr vopuo! be Avaaraer ual Donel Pepa Frameworks PSA 805, Special Considerations — Audits of Single Financial Statements and Specific Elements, Accounts or lems of a Financial Statementri UNDERSTANDING THE AUDIT RISK MODEL Neteee of Risk Riv is A Concept used to express uncertainty about events and/or their outcome, that could have a material effect on the organization. Vike four critical components of risk that are relevant to conducting the audit are: Lf Atadit Risk. The risk that an auditor may give an unqualified opinion on financial statements that are materially misstated. Engagement Risk, The economic risk that a CPA Firm is exposed to simply because it is associated with a particular client including loss of reputation, inability of the client to pay the auditor, or financial loss because tmanagement is not honest and inhibits the audit process. Engagement risk +8 controlled by careful selection and retention of client. ancial Reporting Risk. Those risks that relate directly to the recording vof transactions and the presentation of financial data in an organization's fivancial statements, Rusiness Risk, Those risks that affect the operations and potential outcomes of organizational activities, The following considerations are important in integrating the concepts of materiality and risk in the conduct ofa risk-based audit: 1. Risky areas of a business must be identified by the auditors to determine which account balances are more prone to material misstatements, how the misstatements might occur and how a client might be able to cover them up. Auditors need to develop approaches and methodologies to allocate overall assessments of materiality to individual accoum balances because some account balances may be more important to users. Audits involve testing or sampling and thus cannot provide absolete (100%) assurance that the financial statements are free of material misstatements without inordinately driving up the cost of audits. ‘Not all clients are worth accepting. Since audits rely on testing and to some extent on the integrity of management. there are some clients that an walt finn should act accept because the engagement risk is too high. “ Competition for clients among audit finns is high. Clients choose avdilor °, based on a number of factors including fees, service, industry Personal rapport and ability to assist the client.A Rake Raned Appranach ts Combing a Qwaligy Anat 1S Auditors should understand society’s expectations of financial reporting. tw reduce audit risk te an acceptably low level and therefore minimize lawsuits that the users may possibly bring forth, Although audit risk is a concept, it is ofen illustrated using quantitative examples. For instance, the relationship between engagement risk and audit risk may be presented as follows: © Setting audit risk at 1% is equivalent to performing a statistical test using 99% confidence level. Audit risk sct at 1% implies that the auditor is willing to take a chance of issuing an unqualified opi materially misstated financial statements. © Audit risk set at 3% plies that the auditor is willing to take a 5% chance of issuing an unqualified opinion on matcrinlly misstated financial statements. © High levels of audit risk are appropriate for client with lower levels of engagement risk. Based on the assessment of engagement risk. the auditor sets the desired audit risk. Audit risk oftentimes illustrated using numeric or quantitative examples. In fact many audit firms use the measures associated with statistical sampling to set audit risk, e.g... setting audit risk at a 1% level for high-risk clients and 5% for lower-risk clients. Other auditing firms use a broader description of audit risk as high, moderate or low and adjust the nature of their audit procedures accordingly. The following general observations are considered to have influenced the implementation of the audit risk model: The better the company's internal controls, the lower the likelihood of material misstatement. © Unusual or complex transactions are more likely to be erroneously recorded than am recurring or routine transactions, sO . The amount and persuasiveness of audit evidence gatbered should vary inversely with audit risk; i.c., lower audit risk requires gathering more: persuasive evidence.te Cher f $$$. COMPONENTS OF AUDIT-RISK BIODEL The Seneral premises have been inewporated info an audit Fisk (AR) megs with thive compuments: inherent rish (IK), control, risk (CR) and “ee (DRY a8 follows: AR = IRA CRS DR | where Inherent rick (IR) is the initial susceptibility of a transaction or SE COunting audjustment 10 be recorded in error, oF for the transaction not to be recorded ia the absence of internal controls. Control risk (CR) is the risk that the client's internal control sysiem will fail jg Prevent or detect a misstatement, Detection risk (OR) is the risk that the audit procedures will fail to detect g material misstatement, Stated differently, autit risk is the risk that the auditor May give an unqualified opinion on materially misstated financial statements. It is influenced by: (12) the likelihood that a transaction, estimate, or adjustment might be recorded i CR) the likelihood that the client's internal contol Processes would fail (0 prevent or detect the misstatement and (DR) the likelihood that, if a nusstatement occurred, the auditor's procedures would fail to detect the misstatement, The audit risk model may also be illustrated using a quantitative approach with probability assessments applied to each of the model's component. Illustrative Case I: Quantitative Example of Audit Risk: High Risk of Material Misstatement XYZ Mining Corporation. an audit client of Aquino and Marcos CPAs. has ‘ many complex transactions and weak internal control. The auditors assess both inherent risk and control risk at their maximum. This implies that the client do not have effective control (CR) and there is a high risk that the transaction be recorded incorrectly (IR). The auditors believe that engagement risk is high and have set audit risk se 0.01 level. This means that the auditors do not want to take much of a Fisk the misstatement goes undetected in the financial statements.A Rinks Based Approach to Conductune a Quality Audit 1% ‘The effect on the extent of audit procedures and thus, detection risk is as follows: AR = Rx CK x DR DRe _AK__ (IR x CR) DR 01 or 0.01 or 1% (1.0 x10) In this particular cave, detection risk and audit risk are the same because the auditer cannot rely on internal contro! to prevent or detect misstatements. ‘This illustration therefore yields the instinctive result: "Poor contmls and a high likelihood of misstatement would lead to extended audit work to maintain audit risk at an acceptable level.” IMustrative Case II; Quantitative Example of Audit Risk: Law Risk of Material Misstatement Zonen Trading Corporation is an audit client of Cayetano and Loren CPAs. Zoren has simple transactions, well-trained accounting personnel effective control and nu incemtive to misstete the financial statements. ‘The auditor's previous audit experience with the client; an understanding of the client's intemal controls and the results of preliminary testing this year indicate a low risk of material misstatement existing in the accounting records. The auditor assesses inherent risk as low as 50% and control risk of 20%. Audit risk is consistent with it low engagement risk of 0.05. ‘The detection risk for this engagement is determined as follows: DR= _AR__ (IR x CR) DR> _05__ (50 x20) of 0.50 or 50%8 Chapter§ The auditor could therehre di tests of the accounting record: detection risk, in this situation 50%, because only minimal subst IVE tests of account balances are needed to provide corroborating evidence Othe expectations that the accounts are not materially misstated. The auditor, howeye, would have had to test whether the controls are operating effectively in order 4p support a control risk assessment belaw 100%. FACTORS TO CONSIDER IN IMPLEMENTING THE AUDIT Risx MODEL The following general obscrvations on on audit clicnt influence the implementation of the audit risk model: 1. High-risk activities © This includes operations or events where a material misstatement could casily occur. For example, an inventory of high-value diamonds or gold bars held by a jeweler, or a new / complex accounting system being introduced. i 2. Existence of large non-routine transactions . © Identified significant related party transactions outside the entity’s normal course of business are to be treated as giving rise to significant risks. This includes infrequent and large transactions. For example: Unusual volume of routine transactions with a related party; + A major sales or supply contract, . ¢ The purchase or sale of major business assets or business segments; and % Sale of the business toa third party. * Routine non-complex transactions that are subject to systemslié processing are less likely to give rise to significant risks. _ 3. Matters requiring judgmeni or management intervention e Examples would include: _ The assumptions and calculations used by managemest developing major estimates; * “s > Complex calculations or accounting principles; a is ? Revenue recognition (presumed to be a significant-isk) 4 subject to differing interpretation;4 Rist-Baved Approach to Conducting & Quality Audit 1% Where management intervention is required to specify the accounting treatment to be used. 4. Potential for sraud © The risk of not detecting a material misstatement resulting from fraud (which is intentional and deliberately concealed) is higher than the risk of not detecting one resulting from error. © In evaluating whether significant risk could result from the identified fraud risk factors and the possible scenarios and schemes identified in team discussions, consider the following: % Skillfulness of the potential perpetrator: > Relative size of individual amount manipulated; Level of authority of management or employee to: + directly or indirectly manipulate accounting records, and = override control procedures; * — Significant fraud risks may be identified at any stage in the audit as a result of new information being obtained. LIMITATIONS OF THE AUDIT RISK MODEL Audit risk is a concept that drives the auditor's thinking about planning the audit and then executing an audit. The illustrations are designed to provide guidance, but should not be applied rotely to any audit client. CPA firms in determining their approach to implementing the audit risk model should consider the following limitations: a) Inherent risk is difficult to formally assess. Some transactions because of their complexity are more susceptible to error but it is quite difficult to assess that level of risk independent of the client's accounting system. b) The model treats each risk component as separate and independent when in fact the components are not independent. It is also quite difficult to separate a client's material controls and inherent risk. a) Audit risk is judgmentally determined. d) Audit technology is not so fully developed that ‘each component of the model can be accurately assessed. Auditing is based on testing and precise estimates of the model’s components are not possible. Auditors can, however, make subjective assessments and use the audit risk model as. guide.20 Chapter I REVIEW QUESTIONS Questions : 1. Explain why auditors’ reports are important 10 users of finan statements, mola 2. What purpose is served by the Philippine Standartls on Auditing? 3. Discuss the role of risk in the audit process and how its existence ‘s communicated to the user in the audit report, 4. Prior to naming Cruz and Company as its auditors, Del Pelayo of Verbatim, Inc., met with Gracie Cruz and inquired about the auditors Who would work on Verbatim's audit. Pelayo wants Cruz to assign only Persons who graduated from his alma mater. Required: How should Gracie Cruz respond? 5. Describe the conditions under which an auditor is associated with financial statements. : 6. What factors should an auditor consider in determining whether financial stalements are presented ly in conformity with applicable financial reporting standards? 7. Why must the auditor refrain from explaining why she or he is independent? 8. Define the following terms: a. audit risk €. control risk b, inherent risk d, detection risk 9. a. What is the audit risk model? b. How can an auditor use the audit risk model? 10. Describe the relationship between detection risk and cvidence accumulation. 11. Below are an auditor's planned audit risk and assessment of inherent isk “| and control risk for five situations._A Risk-Based Approach ta Conducting a Quality Audit 21 Required: a. Determine the detection risk that can be allowed for each situation. b. Rank the five situations, based on the amount of audit evidence that will be needed, You may assume that all other factors that may affect audit evidence accumulation are the same. ° 12. Last year you were assigned to minor parts of the audit of the sales and collections cycle for Patrick Corporation. This year you have beea assigned significant responsibility in the audit of the sales and collections cycle. You recall that last ycar, the credit manager, Josie Tan, treated you as if you were one of the clerks. In fact, you had to call her "Ms. Tan" when you went to ask her several questions, This year, she has become very friendly. Josic, as she now wants you to call her, has just invited you to join her for dinner at a very exclusive private club in town. You were called away before you could give Josie a reply, but she did indicate to-you that last year she took your predecessor to sucha dinner. Required: How do you respond to Josie? 13. The fairness of financial statements and the adequacy of internal controls are judged only by reference to pre-established criteria. What serves 2s the criteria to judge the faimess of financial statements and the adequacy of internal controls? Explain why “reference to criteria” is important to the audit function and the results communicated by the audit function. 14, How does complexity affect (1) the demand for auditing services and (2) the performance of auditing services? 15. Who is the most important user of an auditor's report on a company's financial statements: company management, the company's shareholders, or the company's creditors? Briefly explain your rationale and indicate how auditors should resolve potential conflicts in the needs of the three parties. 16. How does an audit enhance the quality of financial statements and management's reports on internal control? Does an audit ensure a fair presentation of a company’s financial statements or that internal control systems are free of material deficiencies? Explain. 17, In what ways does the practice of internal auditing differ from the practice of public accounting? To whom is the internal auditing function responsible?18 Maria Cruz & Co, CPAs, is planning its audit procedures for the valuation of inventories of Eastem Manufacturing Co. The on the engagement have assessed inherent risk and control Tisk fo valuation of inventories at 100 percent and 50 Percent, respectively, Required: a Calculate the appropriate level of detection risk for the audit Of this assertion, given that the auditors wish to restrict audit risk for the assertion to 3 percent. Calculate the appropriate level of detection risk for the audit of this assertion, given that the auditors wish to restrict audit risk for the Assertion to 5 percent. . State whether each of the following statements is correct or incorrect concerning audit risk and its components — inherent risk, control risk, and detection risk, a. b. The risk of material misstatement is composed of the three components of audit risk. Inherent risk is the possibility of material misstatement before considering the client's ii control. Less contro! risk means in increase in the risk of material misstatement. Detection risk does not exist when no audit is performed. Rather than restrict detection risk through the Performance of more Substantive procedures, auditors assess it. Absent any other changes. an increase in the risk of material misstatement results in an increase in audit risk. Audit risk refers to the possibility that the auditors may unknowingly fail to appropriately modify their opinion on financial statements thal are materially or immaterially misstated. Both inherent risk and control risk exist independently of the avdit of financial statements. . In applying a top-down, risk-based approach to an audit, should the auditor start with the ending account balances or does the auditor stant with the significant processes that lead to material account balances? Is ‘one approach preferred over the other? Explain. its tests of