Auditing Risk Assessment Quiz

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Questions and Answers

What condition is likely to affect the auditor's decision to perform substantive procedures during the interim period?

Expectations of account balance changes (correct)

Auditor's preferences for testing methods

Availability of information at year end (correct)

Nature of substantive procedure (correct)

How does a higher risk of material misstatement (RMM) influence the nature of substantive testing?

More analytical procedures are preferred

Elimination of sample size considerations

Requires more extensive and detailed testing (correct)

Less detailed testing is required

What effect does a lower risk of material misstatement have on the timing of audit procedures?

Internal controls are ignored

All procedures must be done after year end

Procedures are conducted during the interim periods (correct)

Timely audits are discouraged

Which of the following is a concern regarding estimates in auditing?

Estimate uncertainty Signup and view all the answers

What process is essential for auditors to understand concerning accounting estimates?

Inquiring about management's estimation methods Signup and view all the answers

What type of misstatement occurs when an actual error is identified during an audit?

Factual misstatement Signup and view all the answers

Which factor is most likely to result in lower detection risk for auditors?

Relying on strong internal controls Signup and view all the answers

Which of the following statements about the relationship between risk of material misstatement and detection risk is true?

Higher RMM correlates with lower detection risk Signup and view all the answers

What is the primary purpose of sampling in auditing?

To provide a reasonable basis for conclusions about the population. Signup and view all the answers

What is a potential drawback of sampling that relates to sample representation?

It can lead to biased conclusions. Signup and view all the answers

What type of risk occurs when an auditor incorrectly concludes there is a material misstatement?

Risk of incorrect rejection. Signup and view all the answers

Which sampling method involves random selection with an equal chance for every item?

Random sampling. Signup and view all the answers

Statistical sampling requires which of the following?

Random selection and measurement of sample risk. Signup and view all the answers

Which of the following best defines sampling risk?

The possibility of reaching inappropriate conclusions due to a non-representative sample. Signup and view all the answers

Haphazard sampling is characterized by what trait?

Having no use of a methodical technique. Signup and view all the answers

Stratification is used in auditing primarily to achieve what?

To improve audit efficiency before random selection. Signup and view all the answers

What is the primary purpose of breaking the population into groupings with common characteristics during an audit?

To project misstatement found in the sample to the audit population. Signup and view all the answers

Which method involves adding or subtracting the projected difference between audit value and book value?

Difference method. Signup and view all the answers

What are the five elements that an auditor must document concerning an entity’s internal control system?

Control activities, control environment, risk assessment, information and communication, and monitoring activities. Signup and view all the answers

Why is it important for an auditor to assess control risk during the audit planning process?

To gauge the risk of material misstatement due to deficiencies or weaknesses in internal controls. Signup and view all the answers

According to the understanding required, what should an auditor document about deficiencies in internal control?

Document the deficiencies and any material weaknesses identified in the internal control system. Signup and view all the answers

In evaluating sample risks, what is the auditor expected to consider?

Factors that could lead to misstatements throughout the audit process. Signup and view all the answers

How should auditors determine the nature, timing, and extent of audit procedures?

By developing an audit strategy that reflects their understanding of internal controls. Signup and view all the answers

What does the ratio method help auditors achieve during an audit?

It calculates the ratio of sample values to project misstatements to the total population. Signup and view all the answers

What is one purpose of substantive procedures in an audit?

To ensure the accuracy of estimates in financial statements. Signup and view all the answers

Which of the following is NOT a substantive analytical procedure?

Recalculating amounts. Signup and view all the answers

In assessing the allowance for doubtful accounts, which risk assessment procedure is crucial?

Understanding management's estimation process. Signup and view all the answers

For which assertion would an auditor most likely use audit sampling when auditing inventory?

Completeness Signup and view all the answers

When using audit sampling for the completeness assertion, what constitutes the population?

All recorded inventory items. Signup and view all the answers

Which type of risk is characterized by the possibility of incorrectly accepting an assertion as true?

Risk of incorrect acceptance Signup and view all the answers

What implication does the risk of incorrect rejection generally have for the audit process?

It may lead to unnecessary additional testing. Signup and view all the answers

Which of the following is a reason an auditor would prefer audit data analytics over traditional verification methods?

It offers a comprehensive view of trends in large datasets. Signup and view all the answers

What is a key consideration when deciding to move to a reliance strategy in auditing an IT-based accounting system?

Whether the evidence is in electronic format Signup and view all the answers

Under which condition should an audit firm consider hiring an IT specialist?

When the IT system is very complex and advanced Signup and view all the answers

What should auditors ask an IT specialist regarding an automated accounting system?

How the system works and the processes involved Signup and view all the answers

Which of the following internal control components may be affected by transitioning to an IT-based accounting system?

Risk assessment and control environment Signup and view all the answers

Which factor is NOT relevant when assessing the effectiveness of the internal controls in an IT-based accounting system?

Historic glitches in the manual system Signup and view all the answers

Why might an auditor rely more on substantive procedures in an audit?

If internal controls are weak and unreliable Signup and view all the answers

What does the term 'reliance strategy' refer to in auditing?

Relying on the effectiveness of internal controls to reduce substantive testing Signup and view all the answers

What is an important factor to determine the sufficiency of electronic evidence in auditing?

The reliability and relevance of the data Signup and view all the answers

Study Notes

Assessed risk of material misstatement

Auditors are more likely to perform procedures at the interim period if the risk of material misstatement is low.
Auditors are more likely to perform procedures at the interim period if the information available during the interim period is not readily available at year-end.
Auditors are more likely to perform procedures at the interim period if the type of procedure can be performed at the interim period.
Auditors are more likely to perform procedures at the interim period if little change is expected in an account balance during the period from interim to year-end.
Auditors are more likely to perform procedures at the interim if they can do additional procedures during the period after interim and after year-end.

Relationship of RMM and detection risk and the impact on the nature, timing and extent of substantive procedures

Risk of material misstatement (RMM) = inherent risk x control risk
A higher RMM means a lower detection risk.
For a higher RMM, auditors will perform more extensive and detailed testing and use less analytical procedures. For a lower RMM, they'll do the opposite.
For a higher RMM, auditors will perform procedures closer to year-end. For a lower RMM, they'll perform them during interim periods.
For a higher RMM, auditors will use a larger sample size. For a lower RMM, they'll use a smaller sample size and rely more on internal controls.

Types of estimates

Forecasting
Determining fair value

Concerns about estimates

Estimate uncertainty
Management bias

How do we audit estimates?

Gain an understanding of the client's financial reporting framework.
Inquire with management about the process for identifying the need for accounting estimates.
Inquire about how accounting estimates are made, including the method of measurement, the controls in place, the assumptions used, any changes in the methods, and if management has considered the effect of estimation uncertainty.

Different types of misstatements noted during an audit

Factual
Judgmental
Projected

Chapter 10 Why does an auditor use sampling?

To test less than 100% of the population.
To provide a reasonable basis for conclusions about the population.

Drawbacks of sampling

Samples may not be representative of the population.
Samples can be biased.
Sampling can be time-consuming and expensive.
Samples can misrepresent results.

Sampling risk

The possibility that the auditor reaches an inappropriate conclusion because the sample is not representative of the population.
Risk of incorrect acceptance/rejection:
- Risk of incorrect rejection: The auditor concludes that there is a material misstatement when, in fact, there is not.
- Risk of incorrect acceptance: The auditor concludes that there is no material misstatement when, in fact, there is one. This risk is more serious than the risk of incorrect rejection as it indicates a higher risk that the audit will be ineffective.

Statistical vs. non-statistical sampling

Statistical sampling
- Requires random selection of sample items.
- Uses techniques to determine sample size and evaluate sample results.
- Allows for assessing the efficiency of the results.
- Uses smaller samples but can be harder to understand.
Non-statistical sampling
- Does not use techniques to determine sample size or select sample items.
- Is judgment-based, with no math involved.
- Uses larger samples.

Different methods in selecting a sample

Random
Systematic
Haphazard

How we apply non-statistical sampling to account balances

Individually significant items: Items with a significant value that are not included in the sample.
To select a sample:
- The process should be unbiased.
- The auditor should attempt to obtain a representative sample of items.
- Stratification can be used to improve audit efficiency. This involves breaking the population into groupings that have traits in common.
Project the misstatement found in the sample to the audit population:
- Consider sampling risk when evaluating sample risks.
- Two methods to project misstatements are the ratio method and the difference method.

An auditor is required to obtain sufficient understanding of each component of an entity’s internal control system to plan the audit of the entity’s financial statements and to assess control risk for the assertions embodied in the account balance, transaction class, and disclosure components of the financial statements

1. Define internal control

A process effected by an entity's management, board of trustees, and other personnel to provide reasonable assurance regarding the achievement of objectives related to compliance, operations, and reporting.

2. For what purpose should an auditor's understanding of the internal control components be used in planning an audit?

The auditor should understand the internal control components being used in planning an audit to assess the control risk, or the risk of material misstatement due to the internal controls or lack thereof.
This can be because of deficiencies or material weaknesses in the controls.
Auditors should also know the internal controls to help them develop their audit strategy and plan the nature, timing, and extent of audit procedures that need to be performed to have a successful audit.

3. What are an auditor’s documentation requirements concerning an entity’s internal control system and the assessed level of control risk?

The auditor must document their understanding of the internal control system, such as the 5 elements: the control environment, risk assessment, control activities, information and communication, and monitoring activities.
They must also document their assessment of the control risk.
They should include if there are any deficiencies or material weaknesses in the internal control system.

Assume that you are an audit senior in charge of planning the audit of an entity that your firm has audited for the previous four years. During the audit planning meeting with the manager and partner in charge of the engagement, the partner noted that the entity recently adopted an IT-based accounting system to replace its manual system. The manager and partner have limited experience with IT-based accounting systems and are relying on you to help them understand the audit implications of the entity’s change. Consequently, they have asked you to respond to a few concerns regarding automated accounting systems.

1. In previous years, the audit firm has relied heavily on substantive procedures as a source of audit evidence for this entity. Given that the entity now has changed its accounting system, what are some of the factors that you should consider when deciding whether to move to a reliance strategy?

Some factors to consider when deciding whether to move to a reliance strategy are if all evidence is in electronic format and if the system is effective at preventing or detecting and correcting any misstatements.
Auditors should also consider if the test is supported by reliable and relevant data and if the internal controls over data are strong enough to rely on them, therefore doing less substantive testing.

2. Under what conditions should the audit firm consider engaging an IT specialist to assist in the evaluation? If the firm hires an IT specialist, what information should the auditors ask the specialist to provide?

An audit firm should consider engaging an IT specialist to assist in the evaluation when the IT system is very complex and advanced, and therefore, the auditors do not have a complete and full expertise and knowledge about it.
They should also do it if there are significant changes in the processes that the auditors may not know or fully understand.
They should also ask if the evidence available in electronic format is not sufficient enough to meet audit requirements.
The auditors should ask the IT specialist how the system works and the processes.
They should also ask about the design and operating effectiveness of the controls to help them make a sufficient assessment on the internal controls.

How are the five components of the entity’s internal control affected by the entity’s change to an IT-based accounting system?

Control of the environment is the tone of the organization or the culture. If they change it to an IT-based accounting system, then that may change.
Another component is the risk assessment.
The change to an IT-based accounting system may affect the control activities, information and communication, and monitoring activities components.

What are the main types of substantive procedures?

Direct evidence about the completeness, accuracy, validity of data, and reasonableness of estimates in financial statements.
Test of details - Inspection, observation, inquiry, confirmation, recalculation, Reperformance, scanning, and ADA.
Substantive analytical procedures

Using the allowance for doubtful accounts as an example, briefly explain the risk assessment procedures that would be performed on the accounting estimate

Understand the entity and industry.
Understand management's process in estimating allowance for doubtful accounts.
Understand relevant policies that need to be followed.
Understand internal controls related to making the estimate, such as observing, inquiring, inspecting, etc., of how they make the estimate and what they do, etc.

Assume that an auditor is auditing inventory for a computer manufacturer with strong internal controls. Identify one assertion where the auditor is likely to use audit sampling. Explain your reasoning. Then identify another assertion where the auditor is likely to use audit data analytics. Explain your reasoning.

Completeness - ensure all inventory items that should be recorded are actually included on the financial statements
- Use audit sampling to examine a sample of inventory transactions to verify that they were on there
Valuation - determine if inventory is valued appropriately at lower cost or net realizable value
- Analyze sets of data of any outliers or trends, etc.

Using your example of audit sampling in the answer to R10.1, what items make up the population? What items are subject to being sampled? When the sample is complete, is the auditor drawing a conclusion about the sample or the population? Explain your reasoning.

The population would be all inventory items recorded.
Items subject to being sampled could be inventory records that are of higher risk or more significant in value.
When the sample is complete, the auditor is drawing a conclusion from the population because the auditor is determining if the completeness assertion is valid for the entire population based on the sample.

Explain the difference between the two types of sampling risk for substantive procedures: the risk of incorrect acceptance and the risk of incorrect rejection. What are the errors’ different implications for the audit? Which is the more serious risk? Explain.

Risk of incorrect acceptance: Occurs when the auditor concludes that there is no material misstatement when, in fact, there is one. This can lead to the audit being ineffective, meaning the auditor may not have detected a material misstatement that potentially needs to be corrected.
Risk of incorrect rejection: Occurs when the auditor concludes that there is a material misstatement when, in fact, there is not. This can lead to the audit being inefficient, meaning the auditor may have performed unnecessary procedures.
The risk of incorrect acceptance is more serious because it means the auditor may have missed a material misstatement, increasing the risk that the financial statements may be materially misstated.

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Description

Test your knowledge on the assessed risk of material misstatement and its relationship with detection risk. This quiz covers key concepts auditors consider when determining the nature, timing, and extent of substantive procedures. Perfect for students or professionals in auditing and accounting.