Audit Practice II: Materiality and Risk

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Questions and Answers

What occurs when sales transactions are misclassified in financial records?

Sales may not be included in the financial statements.

Transactions are recorded in the wrong journal.

Inaccuracies in the general ledger occur.

Cash sales may be recorded as credit sales. (correct)

Which of the following best describes the timing objective for sales transactions?

Sales must be recorded on the date of shipment. (correct)

Sales should be recorded on the date of billing.

Transactions must be recorded at the close of the accounting period.

Transactions must be summarized with no errors.

What is violated if the quantity shipped differs from the quantity billed in a sales transaction?

The rights and obligations assertion

The completeness assertion

The valuation assertion

The accuracy assertion (correct)

Which scenario exemplifies a violation of the grouping of items in transaction-related audit objectives?

Recording a commercial sale in the residential sales account. (B) Signup and view all the answers

How do balance-related audit objectives differ from transaction-related audit objectives?

They apply to account balances instead of transaction classes. (B) Signup and view all the answers

What is an example of a valuation and allocation assertion failure?

Using an incorrect selling price for billing. (D) Signup and view all the answers

Which of the following best addresses the completeness assertion during a sales transaction?

Ensuring all transactions are recorded. (C) Signup and view all the answers

What issue arises when a sales transaction is reported at an incorrect amount in the general ledger?

It compromises the valuation and allocation assertions. (C) Signup and view all the answers

Which assertion ensures that all transactions that should be recorded have been included in the financial statements?

Completeness (D) Signup and view all the answers

What is typically excluded when assessing inherent risk in an audit?

Internal controls (B) Signup and view all the answers

Which assertion relates specifically to the accuracy and proper valuation of asset and liability accounts?

Valuation and allocation (A) Signup and view all the answers

When determining the control risk component in the audit risk model, what aspect is considered?

The risk of material misstatements being prevented by internal controls (B) Signup and view all the answers

Which transaction-related audit objective focuses on ensuring that transactions have occurred and are valid?

Existence (D) Signup and view all the answers

What does the accuracy and valuation assertion ensure regarding financial information?

Financial information is disclosed fairly and at appropriate amounts. (D) Signup and view all the answers

Which of the following correctly relates to the completeness objective?

All transactions that should be recorded in the journals have been included. (C) Signup and view all the answers

Which statement accurately defines the rights and obligations assertion?

It confirms that ownership of assets and responsibilities for liabilities belong to the entity. (B) Signup and view all the answers

What is the primary focus of the classification and understandability assertion?

Assessing whether descriptions and disclosures are easily interpreted. (D) Signup and view all the answers

What does the occurrence objective ensure in the context of transaction-related audit objectives?

All recorded transactions actually took place. (C) Signup and view all the answers

Which general transaction-related audit objective is focused on the correct amounts of recorded transactions?

Accuracy (C) Signup and view all the answers

Failure to include a sale in the sales journal when a sale occurred violates which objective?

Completeness (B) Signup and view all the answers

Which assertion addresses whether disclosures of management's assumptions are clear?

Classification and Understandability (B) Signup and view all the answers

In the context of presentation and disclosure assertions, what aspect is NOT covered?

Assessment of tax compliance (C) Signup and view all the answers

Which of the following best describes a specific transaction-related audit objective?

Assessing the accuracy of recorded sales transactions. (D) Signup and view all the answers

Which assertion addresses whether all transactions that should be included in the financial statements are actually included?

Completeness (D) Signup and view all the answers

What does the valuation and allocation assertion concern?

Whether transactions are recorded at the correct amounts (D) Signup and view all the answers

What does the rights and obligations assertion refer to?

The legal ownership of recorded assets (C) Signup and view all the answers

Which of the following best describes the presentation and disclosure assertions?

They ensure that financial information is appropriately classified and described. (B) Signup and view all the answers

How does the completeness assertion differ from the occurrence assertion?

Completeness focuses on omitted transactions while occurrence focuses on those included incorrectly. (A) Signup and view all the answers

What is the primary objective of the accuracy assertion?

To confirm recorded amounts are mathematically correct and reflect the intended transactions (A) Signup and view all the answers

Which assertion would be violated by recording a sale in December when the goods shipped in January?

Cutoff (C) Signup and view all the answers

Which assertion checks whether liabilities are presented in the financial statements when they actually exist?

Existence (A) Signup and view all the answers

Internal control systems primarily address which aspect of financial assertions?

Preventing the omission of critical transactions (B) Signup and view all the answers

Which assertion most specifically deals with recording transactions in the relevant financial periods?

Cutoff (B) Signup and view all the answers

Which assertion type addresses whether all transactions that should be recorded are included in the financial statements?

Completeness Assertions (B) Signup and view all the answers

What type of assertion pertains to whether recorded assets are owned by the entity?

Rights and Obligations Assertions (B) Signup and view all the answers

Which assertion type evaluates the accuracy of reported revenues and expenses in relation to their amounts?

Valuation and Allocation Assertions (C) Signup and view all the answers

Which assertion is concerned with the clarity and understanding of information presented in financial statements?

Presentation and Disclosure Assertions (B) Signup and view all the answers

What assertion should an auditor consider when assessing whether the financial statements reflect all financial transactions in the right period?

Transaction-related Audit Objectives (A) Signup and view all the answers

When dealing with complex or nonroutine transactions, what should an auditor assess regarding inherent risk?

Nature of the client’s business (D) Signup and view all the answers

How do auditors determine the risk associated with management's assertions during an audit?

By evaluating the inherent risks of the business (B) Signup and view all the answers

Which factor is NOT typically considered when assessing inherent risk for the audit?

Industry trends and stock performance (B) Signup and view all the answers

In relation to presentation and disclosure assertions, which aspect is crucial for auditors to verify?

That all disclosures are comprehensive and clear (C) Signup and view all the answers

When assessing the risk of financial difficulty, which factor should auditors take into account?

The company's reliance on a single product (C) Signup and view all the answers

Study Notes

Audit Practice and Procedures II

This is a course module.
The focus of Week Five is Materiality and Risk.

Recap of Last Class

Audit Evidence
Types of Audit Evidence
Audit Plan
Audit Documentation

Relationship of Materiality to Type of Opinion

Immaterial: User decisions are unlikely to be affected. Unqualified opinion.
Material: User decisions are likely to be affected only if the information is important to the decisions being made. The overall financial statements are presented fairly. Qualified opinion.
Highly material: Most or all users' decisions based on the financial statements are likely to be significantly affected. Disclaimer or adverse opinion.

Materiality

The magnitude of an omission or misstatement of accounting information.
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.
Auditors are responsible for determining if financial statements are materially misstated.
If a material misstatement is discovered, it must be brought to the client's attention for correction.
If the client refuses, a qualified or adverse opinion is issued.

Auditor's Responsibility

The phrase "obtain reasonable assurance" informs users that auditors do not guarantee the fair presentation of financial statements. Some risk that the statements are not fairly stated exists, even when the opinion is unqualified.
The phrase "free of material misstatement" informs users that the auditor's responsibility is limited to material financial information. Materiality is important because it is impractical to provide assurances on immaterial amounts.

Steps in Applying Materiality

Set materiality for the financial statements as a whole.
Determine performance materiality.
Estimate total misstatement in segment.
Estimate combined misstatement.
Compare combined estimate with preliminary or revised judgment about materiality.
Planning; extent of tests; Evaluating results.

Materiality for Financial Statements as a Whole

Auditing standards require deciding on the combined amount of misstatements in the financial statements that are considered material early in the audit.
This is the preliminary judgment about materiality, which may change during the engagement and must be documented in the audit files.
It's the maximum amount by which the statements could be misstated without affecting decisions of reasonable users.

Factors Affecting Preliminary Materiality Judgment

Materiality is a relative concept, depending on company size.
Benchmarks are needed to evaluate materiality (e.g., net income, net assets).
Qualitative factors also affect materiality (e.g., fraud, contractual obligations, trends in earnings).

Determine Performance Materiality

Performance materiality is lower than materiality for the financial statements as a whole.
It's used to reduce the probability that the aggregate of uncorrected and undetected misstatements exceeds materiality for the financial statements as a whole.
Determining performance materiality is necessary because auditors accumulate evidence by segments, rather than for the entire financial statements.

Auditors' Difficulties in Allocating Materiality

Auditors expect some accounts to have more misstatements than others.
Both overstatements and understatements must be considered.
Relative audit costs affect allocation.

Audit Risk

Auditing standards require the auditor to obtain an understanding of the entity and its environment, including its internal control, to assess the risk of material misstatements in the client’s financial statements.

Audit Risk Model for Planning

PDR = AAR × IR × CR
- PDR = Planned Detection Risk
- AAR = Acceptable Audit Risk
- IR = Inherent Risk
- CR = Control Risk

Audit Risk Model Components

Planned Detection Risk: The risk that audit evidence for an audit objective will fail to detect misstatements exceeding performance materiality.
Inherent Risk: The auditor’s assessment of the susceptibility of an assertion to material misstatement, before considering the effectiveness of related internal controls.
Control Risk: Measures the auditor’s assessment of the risk that a material misstatement could occur in an assertion and not be prevented or detected by the client’s internal controls.
Acceptable Audit Risk: The measure of how willing the auditor is to accept that financial statements could be materially misstated after the audit.

Assessing Acceptable Audit Risk

Auditors must decide on acceptable audit risk, preferably during audit planning. Engagement risk is considered, risk the auditor or audit firm might face after the audit. Client business risk is directly related.

Factors Affecting Acceptable Audit Risk

External users' reliance on statements (e.g., company size, ownership, liabilities)
Likelihood of financial difficulties (e.g., liquidity, profits/losses, financing method)
Management integrity

Liquidity, profits (losses), Method of financing growth & Competence of management

These factors are indicators of increased probability of financial failure, according to the slides.

Factors Affecting Inherent Risk

Nature of the client's business
Results of previous audits
Initial versus repeat engagement
Related parties
Complex or nonroutine transactions
Judgment required to correctly record account balances
Makeup of the population
Factors related to fraudulent financial reporting
Factors related to misappropriation of assets

Financial Statements Assertions

International auditing standards and AICPA classify assertions into three categories:
- Assertions about classes of transactions and events for the period under audit.
- Assertions about account balances at period end.
- Assertions about presentation and disclosure.

Assertions About Classes of Transactions and Events

Occurrence: Recorded transactions have occurred and pertain to the entity.
Completeness: All transactions that should have been recorded have been recorded.
Accuracy: Amounts and other data relating to transactions and events have been recorded appropriately.
Classification: Transactions and events have been recorded in the proper accounts.
Cutoff: Transactions and events have been recorded in the correct accounting period.

Assertions About Account Balances

Existence: Assets, liabilities, and equity interests exist.
Completeness: All assets, liabilities, and equity interests that should have been recorded have been recorded.
Valuation and allocation: Assets, liabilities, and equity interests are included at appropriate amounts.
Rights and obligations: The entity holds or controls the rights to assets, and liabilities are the obligation of the entity.

Assertions About Presentation and Disclosure

Occurrence and rights and obligations: Disclosed events and transactions have occurred and pertain to the entity.
Completeness: All required disclosures have been included in the financial statements.
Accuracy and valuation: Financial and other information is disclosed appropriately and at appropriate amounts.
Classification and understandability: Financial and other information is appropriately presented and described and disclosures are clearly expressed.

Occurrence: Recorded transactions actually occurred.
Completeness: All transactions that should have been recorded were recorded.
Accuracy: Recorded transactions are stated at correct amounts.
Posting and summarizing: Recorded transactions are included and summarized properly in master files.
Classification: Transactions are included in correct accounts.
Timing: Transactions are recorded on correct dates.

Balance related audit objectives are similar to transaction-related objectives; they address account balances (e.g., Accounts Receivable, Inventory, Notes Payable).
Related audit objectives to manage assertions.

Interim Audit

Examination of books of accounts before the annual audit.
Aims for early identification of threats and corrective measures.
Helps determine profitability and dividend suitability.
Improves efficiency and fraud detection.

Interim Audit Characteristics

Conducted between two periods, sometimes called a half-yearly audit.
In-depth analysis of all transactions over a defined period.
May be conducted to determine book value of a company’s share.
Organizations with an interim audit are often considered more reliable.

Final Audit

Completed after the financial year-end, after the final accounts are prepared.
It also known as a periodic audit.
Starts after the close of books of accounts.

Advantages of Final Audit

Economical: The fee can be based on time spent.
Staff Duties: No clash between accounting and audit staff.
Convenient for Management: Clear queries on the same day.
Minimum Time Period: Less time required compared to continuous audits.
Planned Work: Audit work completed under planning, with a scheduled program.
Work Continuity: No breaks in the audit process.
No Change in Figures: The books are in the custody of auditors, so manipulating is not easy after completion of accounts.
Small Business: The fee is less compared to continuous audits.
No Relations: Auditor and accounting staff don’t develop friendly relations.
Full Information: The auditor can take decisions on audit completion and submission.
Thorough Checking: Complete checking or sampling.
Legal Requirements: Compliance with legal requirements is verified.
Performance: Weakness in employees' and management’s performance can be determined.

Disadvantages of Final Audit

Late Correction: Errors are located after the year-end and corrections take longer.
Accounts Delayed: Delays in preparing financial accounts.
Audit Report: Delay in providing the completed audit report.
Low Moral Check: Lower pressure on employees to maintain high work standards.
Planned Frauds: Employees may have more time to commit fraud.
Past Data: Audit is based on the previous year’s data; present or future matters are not considered.
Thorough Checking: Difficulty in thorough checking when audit sampling is used.
Planning for Future: Difficult time constraints if financial forecasts are needed.
Limited Time: Limited time for the auditor to conclude audit work for all clients.

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Description

This quiz assesses your understanding of materiality and risk in the context of auditing practices. Learn about the relationship between materiality and the type of opinion, including unqualified, qualified, and adverse opinions. Test your knowledge on audit evidence and its significance in preparing audit documentation.