ACCT 3109 Auditing Past Paper PDF Fall 2024/25

Materiality Materiality Levels Exhibit 7.2 - Risks Relevant to the Audit Assessing Inh...

Materiality Materiality Levels Exhibit 7.2 - Risks Relevant to the Audit Assessing Inherent Risk at Assertion/Account Level Example: Tencent Holding Limited ACCT 3109 – Auditing Materiality judgments: 1. Overall materiality The following factors should lead an auditor to assess Are a matter of professional judgment Also known as planning materiality assertion level inherent risk higher: Depend on the needs of a reasonable person relying on the What should be the key business and audit risk of Tencent? information Used in determining whether the financial statements overall The account balance represents an asset that is relatively Planning the Audit: Identifying, Assessing, and Involve both quantitative and qualitative considerations are materially correct easily stolen, such as cash https://www.tencent.com/en-us/investors.html#investors-con-2 Responding to the Risk of Material Auditors make materiality judgments for purposes of: 2. Performance materiality The account balance is made up of complex transactions The account balance requires a high level of judgment or Misstatement Audit planning and Also known as tolerable error Evidence evaluation after audit procedures are completed Used for determining significant accounts, significant locations, estimation to value Materiality judgments provide a basis for: and audit procedures for those accounts and locations The account balance is subject to adjustments that are not in the ordinary processing routine, such as year-end adjustments Chapter 7 Determining the nature and extent of risk assessment procedures 3. Posting materiality Identifying and assessing the risks of material misstatement The account balance is composed of a high volume of Determining the tests of controls and substantive audit procedures Signifies the misstatements identified throughout the audit Fall Semester, 2024/25 nonroutine to perform that will be considered at the end of the audit in determining Dr. Sammy Fung whether the financial statements overall are materially correct 1 2 3 19 20 21 Risk Assessment Procedures for Assessing Control Planning Materiality Typical Materiality Judgments Considerations When Setting Materiality Assessing Control Risk at Assertion/Account Level Risk Assessing Fraud Risk Guidance and decision aids to assist auditors in making Financial statement items on which users will focus their The following factors can lead auditors to assess control Interview relevant parties Brainstorming consistent materiality judgments attention risk at a higher level: Review the risk-based approach used by the internal audit Suspension of criticism function Guidelines usually involve applying a percentage to some Nature of the client and industry Poor controls in specific countries or locations Freedom of expression Interview management about its risk approach, risk preferences, risk appetite, and the relationship of risk analysis Quantity of idea generation benchmark, such as Size of the client Difficulty gaining access to the organization or determining the individuals who own and/or control the organization to strategic planning Respectful communication Total assets Manner in which the client is financed Little interaction between senior management and operating Review outside regulatory reports Steps in brainstorming sessions Total revenue Volatility of the benchmark staff Review company policies and procedures for addressing risk 1. Review prior year client information Net income Gain a knowledge of company compensation schemes Intensity of the level of analyst following Lack of supervision of accounting personnel 2. Consider client information, particularly with respect to the Review prior years’ work fraud triangle Review risk management documents 3. Integrate information from Steps 1 and 2 into an assessment of Determine how management and the board monitor risk; the likelihood of fraud in the engagement identify changes in risk; and react to mitigate, manage, or 4. Identify audit responses to fraud risks control the risk 4 5 6 22 23 24 Using Planning Analytical Procedures to Assess the Using Planning Analytical Procedures to Assess the Check Your Basic Knowledge—True/False Check Your Basic Knowledge (7-3) Check Your Basic Knowledge (7-4) Risk of Material Misstatement—Steps 1–4 Risk of Material Misstatement—Steps 5–7 Types of Analytical Procedures 7-1 The auditor bases materiality solely on quantitative factors. 7-3 Which of the following statements is true regarding materiality? 7-4 Which of the following statements is true concerning 1. Determine the suitability of a particular analytical procedure 5. Compare the client’s recorded amounts with the auditor’s for given account(s)/assertion(s), considering the risks of Trend analysis (e.g. 5-years pattern) (T/F) a. Materiality is the magnitude of an omission or misstatement of performance materiality? expectation to determine any significant unexpected accounting information that, in light of surrounding circumstances, a. Performance materiality is set less than overall material misstatement. differences. Ratio analysis (e.g. inventory turnover ratio) 7-2 Performance materiality is an amount less than overall makes it probable that the judgment of a reasonable person relying materiality and helps the auditor determine the extent of materiality and helps the auditor determine the extent 2. Evaluate the reliability of data that the auditor is using to 6. Investigate significant unexpected differences. Recall that for on the information would have been changed or influenced by the of audit evidence to obtain. develop an expectation of account balances or ratios. (e.g. audit evidence needed. (T/F) omission or misstatement. comparing two years’ gross margin to assess the planning analytical procedures, significant unexpected Why do we need to compare two years inventory turnover b. Materiality is the magnitude of an omission or misstatement of b. If performance materiality is set too low, the auditor reasonableness of sales and COGS figures) differences suggest that substantive procedures for the ratio? accounting information that, in light of surrounding circumstances, might not perform sufficient procedures to detect account/assertion will be increased. makes it possible that the judgment of a reasonable person relying 3. Develop an expectation of recorded account balances or What are the implications if two years inventory turnover on the information would have been changed or influenced by the material misstatements in the financial statements. ratios, and evaluate whether that expectation is precise 7. Ensure that the following have been appropriately ratios differ? omission or misstatement. c. If performance materiality is set too high, the auditor enough to accomplish the relevant objective. documented: c. A fact is material if there is a substantial likelihood that a might perform more substantive procedures than 4. Define when the difference between the auditor’s expectation Auditor’s expectation from step 3, including the factors that the reasonable investor would have viewed the fact as having necessary. and what the client has recorded would be considered auditor considered in developing the expectation significantly altered the total mix of information made available. significant. d. Performance materiality is essentially the same as The results in step 4 d. Both (a) and (c) are correct. e. Both (b) and (c) are correct. overall materiality. The audit procedures conducted relating to steps 5 and 6 7 8 9 25 26 27 Identifying and Assessing the Risk of Material Exhibit 7.3 Misstatement Client Business Risks—Higher Level (1 of 2) Client Business Risks—Higher Level (2 of 2) Check Your Basic Knowledge—True/False Check Your Basic Knowledge (7-7) Client Business Risks Examples of factors that would lead the auditor to assess client business Expansion of the business for which the demand for the company’s 7-5 Detection risk is the susceptibility of an assertion to a 7-7 Which of the following statements represents the risk at a higher level products or services has not been accurately estimated material misstatement before consideration of related appropriate directional relationships? Are risks affecting the business operations and potential outcomes of an organization’s activities. The company lacks personnel or expertise to deal with the changes in the A new business strategy is incompletely or improperly implemented controls. (T/F) a. As inherent risk increases, audit risk increases. industry Likely have pervasive effects across an organization Financing is lost due to the company’s inability to meet financing 7-6 Some level of control risk is always present in an b. As inherent risk increases, audit risk decreases. New products and service offerings have uncertain likelihood of successful requirements organization because of the inherent limitations of internal Can potentially affect the risk of material misstatement for introduction and acceptance by the market c. As control risk increases, detection risk decreases. many accounts and assertions Competence and integrity of financial and accounting management control. (T/F) The use of information technology is incompatible across systems and d. As control risk increases, inherent risk decreases. Potential incentives to misstate the financial statements processes 10 11 12 28 29 30 Exhibit 7.1 - Questions to Ask When Assessing Financial Exhibit 7.1 - Questions to Ask When Assessing Financial Exhibit 7.1 - Questions to Ask When Assessing Financial Exhibit 7.5 - Effect of Risk Assessment Responding to Identified Risk of Material Reporting Quality (1 of 3) Reporting Quality (2 of 3) Reporting Quality (3 of 3) Check Your Basic Knowledge (7-8) on Risk Response Misstatement What are the significant judgment areas (reserves, contingencies, asset values, note Were there any significant changes in accounting policies or in the application of Do the accounting choices made reflect the economic substance of transactions 7-8 Which of the following statements is false regarding disclosures) that affect the current-year financial statements? What considerations accounting principles during the year? If yes, why were the changes made and and the strategic management of the business? If not, where are the exceptions planning analytical procedures? Determining evidence needed in the audit were involved in resolving these judgment matters? What is the range of potential what impact did the changes have on earnings per share (EPS) or other key and why do they exist? impact on future reported financial results? financial measures? a. The precision of the auditor’s expectation tends to be less precise, Application of the audit risk model: high risk of material To what extent are the financial reporting choices consistent with the manner in What issues or concerns exist that could adversely affect the future operations Were there any significant changes in accounting estimates or models used in which the company measures its progress toward achieving its mission internally? If and based on more aggregated data, for planning analytical misstatement procedures than for substantive analytical procedures. and/or financial condition of the company? What is management’s plan to deal making accounting estimates during the year? If yes, why were the changes made not, what are the differences? Application of the audit risk model: low risk of material with these future risks? and what impact did the changes have on EPS or other key financial measures? b. The objective for planning analytical procedures is to identify How do the significant accounting principles used by the company compare with accounts with heightened risk of misstatement to provide a basis misstatement What is the overall quality of the company’s financial reporting, including the Are there any instances where the company may be thought of as pushing the leading companies in the industry, or with other companies that are considered for designing and implementing responses to the assessed risks. Audit procedures to respond to the assessed risk of material appropriateness of important accounting principles followed by the company? limits of revenue recognition? If so, what is the rationale for the treatment chosen? leaders in financial disclosure? What is the rationale for any differences? c. For planning analytical procedures, significant unexpected misstatement What is the range of acceptable accounting choices the company has available to Have similar transactions and events been treated in a consistent manner across Has there been any instance where short-run reporting objectives (e.g., achieving a differences suggest that the auditor will need to increase it? divisions of the company and across countries in which the company operates? If profit objective or meeting bonus or stock option requirements) were allowed to substantive procedures. To determine the Nature, Extent, Timing (“NET”) of risk not, what are the exceptions and the reasons for them? influence accounting choices? If yes, what choices were made and why? d. A frequently used planning analytical procedure is regression responses analysis. 13 14 15 31 32 33 Risk Assessment Procedures for Assessing Client Responding to Identified Risk of Material Responding to Identified Risk of Material Risks and Their Effects on Substantive Procedures Business Risks The Audit Risk Model The Audit Risk Model Misstatement Misstatement (1 of 3 for Exhibit 7.4) Management inquiries Desired Level of Audit Risk: 1% Risks included in Audit Risk Model Nature, timing, and extent of risk responses Timing Review of client’s budget Interpretation: Auditor is willing to take only a 1% chance of expressing an audit Audit Risk is the risk that an auditor expresses an Nature Audit procedures are conducted at announced or predictable times Tour of client’s plant and operations when risk of material misstatement is low opinion that the financial statements are fairly presented when they are materially inappropriate opinion on the financial statements; Analytical procedure, test of transactions or test of balances Audit Risk = Inherent Risk × Control Risk × misstated. Review relevant government regulations and client’s legal Direct testing or indirect testing But, when risk of material misstatement is heightened obligations Inherent Risk is the risk of a material misstatement in the Risk of material misstatement (combines inherent and control risks): High Knowledge management systems Detection Risk financial statements arising due to error or omission as a Types of audit procedures applied given the nature of account balance and relevant assertions regarding that account balance Audit procedures conducted closer to year end on an unannounced basis Interpretation: High likelihood that assertion/account contains a material Online searches result of factors other than the failure of control; Procedures misstatement Some element of unpredictability included in timing Review of SEC filings Control Risk is the risk of a material misstatement in the Assembling audit team with more experienced auditors Effect on detection risk: Detection risk will be at a lower level Why multiplication, not addition? Including on audit team outside specialists Some procedures that can be completed only at or after period end Company websites financial statements arising due to absence or failure in the Auditor is willing to take a lower risk that substantive procedures will not detect Increasing emphasis on professional skepticism Comparison of financial statements to accounting records Economic statistics operation of relevant controls of the entity; a material misstatement. Extent Evaluation of adjusting journal entries made by management in Professional practice bulletins Detection Risk is the risk that the auditors fail to detect a preparing financial statements Effect on sufficiency and appropriateness of substantive procedures Amount of evidence (e.g. sample size) that is necessary given client’s Stock analysts’ reports material misstatement in the financial statements. assessed risks, materiality, and level of acceptable audit risk Conduct procedures to respond to risks that management may More, and/or more appropriate, evidence from substantive procedures Company earnings calls When risk of material misstatement is heightened, auditor increases have engaged in improper transactions at period end (e.g. bad debt extent of audit procedures and demands more evidence and other accruals estimate) 16 17 18 34 35 36 Risks and Their Effects on Substantive Procedures Risks and Their Effects on Substantive Procedures (2 of 3 for Exhibit 7.4) (3 of 3 for Exhibit 7.4) Check Your Basic Knowledge—True/False Desired Level of Audit Risk: 5% Desired Level of Audit Risk: 5% 7-9 A high level of detection risk means that the audit firm is Interpretation: Auditor is willing to take a 5% chance of expressing an audit Interpretation: Auditor is willing to take a 5% chance of expressing an audit willing to accept a low risk of not detecting a material opinion that the financial statements are fairly presented when they are materially opinion that the financial statements are fairly presented when they are materially misstated. misstated. misstatement. (T/F) Risk of material misstatement (combines inherent and control risks): Moderate Risk of material misstatement (combines inherent and control risks): Low 7-10 The nature of risk response refers to the sufficiency and appropriateness of evidence that is necessary given the risk Interpretation: Moderate likelihood that assertion/account contains a material Interpretation: Low likelihood that assertion/account contains a material misstatement misstatement of material misstatement and the level of acceptable audit Effect on detection risk: Detection risk will be at a moderate level. Effect on detection risk: Detection risk will be at a higher level risk. (T/F) Auditor is willing to take a moderate risk that substantive procedures will not Auditor is willing to take a higher risk that substantive procedures will not detect detect a material misstatement. a material misstatement. Effect on sufficiency and appropriateness of substantive procedures Effect on sufficiency and appropriateness of substantive procedures Moderate, and/or moderately appropriate, evidence from substantive Less, and/or less appropriate, evidence from substantive procedures procedures 37 38 39 Check Your Basic Knowledge (7-11) Check Your Basic Knowledge (7-12) 7-11 Assume that the auditor sets audit risk at 1%. What is the 7-12 Which of the following statements is false regarding the appropriate interpretation of this level of audit risk? nature, timing, and extent of risk responses? a. The auditor is willing to take only a 1% chance that audit a. The nature of risk response refers to the types of audit procedures procedures will not detect a material misstatement. applied given the nature of the account balance and the most relevant assertions regarding that account balance. b. The auditor is 99% confident that the audit procedures b. The timing of risk response refers to when the auditor performs the will detect a material misstatement. audit procedures. c. The auditor is willing to take only a 1% chance of c. When the risk of material misstatement is low, the auditor conducts expressing an audit opinion that the financial the audit procedures closer to yearend, on an unannounced basis, and includes more elements of unpredictability in the procedures. statements are fairly presented when they are materially d. The extent of risk response refers to the sufficiency of evidence that misstated. is necessary given the client’s assessed risks, materiality, and the d. The auditor is 99% confident that the audit opinion is acceptable level of audit risk. correct. 40 41  Revenue Cycle Transactions Inherent risk - Revenue Inherent risk - Accounts Receivable ACCT 3109 – Auditing 1. Receive a customer purchase order Timing of revenue recognition Some inherent risks affecting receivables include: 2. Check inventory stock status Criteria for Revenue Recognition Receivables are pledged as collateral against specific loans with restricted use (disclosures of such restrictions are required). 3. Obtain credit approval 1. Identify the contract with the customer Receivables are incorrectly classified as current when the 4. Prepare shipping and packing documents 2. Identify the performance obligations likelihood of collection during the next year is low. Auditing the Revenue and Payment Cycle 5. Ship and verify shipment of goods 3. Determine the transaction price Collection of a receivable is contingent on specific events that 6. Prepare and send the invoice 4. Allocate the transaction price to the deliverables cannot currently be estimated. 7. Send monthly statements to customers 5. Recognize revenue when (or as) you satisfy performance Payment is not required until the purchaser sells the product 8. Receive payments to its end customers. obligations Accounts receivable are aged incorrectly, and potentially Chapters 9 & 11 uncollectible amounts are not recognized. When should we prepare journal entries? When to recognize Orders are accepted from customers with poor credit, but the Fall Semester, 2024/25 sales? allowance for doubtful accounts is not increased accordingly. Dr. Sammy Fung 1 2 3 4 Check Your Basic Knowledge (9-7) Identifying Fraud Risks How Do Fraudsters Perpetrate their Schemes? Lapping Research indicates that over 60% of frauds involve Recognizing revenue on shipments that never occurred or that A technique used to cover up the embezzlement of cash. 9-7 Under the FASB’s guidance on revenue recognition, which of occurred after the end of the period the following is not a criteria that must be met in order for a inappropriate revenue recognition. Utilizing hidden side letters A cash collection from one customer is stolen by an contract to exist? Virtually every client has revenue, so identifying fraud Recording consignment sales as final sales employee who takes another customer’s payment and a. The parties have approved it. risks relating to revenue recognition is critical. Shipping unfinished products, those that the customer never credits the first customer. ordered, or before the customers agreed to delivery b. The auditor has ensured that the contract’s valuation is Auditing standards state that auditors should ordinarily Creating fictitious invoices This process continues, and at any point in time at least reasonable in all material respects. presume there is a risk of material misstatement caused Recording shipments to the company’s own warehouse as outside one customer’s account is overstated. by fraud relating to revenue recognition. sales c. The goods and/or services involved are clearly identified. Shipping goods that had been returned and recording the d. The payment terms are spelled out. reshipment as a sale of new goods before issuing credit for the returned sale e. There is commercial value to the contract. Incorrect aging accounts receivable and not recording write-downs of potentially uncollectible amounts Recording purchase orders as completed sales 5 6 7 8 Identifying Fraud Risk Factors Check Your Basic Knowledge (9-11) Check Your Basic Knowledge (9-12) Identifying Control Risks Assessing motivation to enhance revenue because of either internal 9-11 Which of the following factors is not a motivation for 9-12 Which of the following explanations best describes the Requires understanding of internal controls for integrated or external pressures clients to fraudulently misstate revenue? purpose of lapping? audits and financial statement only audits Reviewing the financial statements through planning analytical procedures to identify account balances that differ from a. Bankruptcy may be imminent. a. Lapping is a technique used by client personnel to cover Such understanding is gained by: expectations or general trends in the economy up the embezzlement of cash. Walkthrough of the process b. Management bonuses are contingent on a certain Recognizing that not all of the fraud will be instigated by Inquiry management revenue goal. b. Lapping is an approach used by client personnel to Becoming aware of representations made by management to eliminate differences between a customer’s records and Observation c. Controls over revenue process are ineffective. analysts the client’s records reported on confirmations. Review of client’s documentation Determining whether the company’s accounting is being d. Management wants to meet publicly announced earnings expectations. c. Lapping is a procedure used by the auditor to obtain At account and assertion levels auditor considers: investigated by organizations such as the SEC evidence the client’s customer does return a positive Entity-wide controls Considering management compensation schemes, especially those that rely on stock options and therefore current stock prices confirmation. Commitment to financial accounting competencies Determining whether accounting functions are centralized, and if Independence of the board of directors d. Lapping is an agreement containing contract terms that not centralized, assessing if the decentralization is appropriate Transaction controls are not part of a formal sales contract. 9 10 11 12 Controls Related to Existence/Occurrence of Revenue and Accounts Receivable Controls Related to Completeness Controls Related to Valuation Documenting Controls Providing reasonable assurance that sale and accounts Use of prenumbered shipping documents and sales Limiting access to the files to authorized individuals Internal control questionnaire for sales and accounts receivable are recorded only when: invoices and the subsequent accounting for all numbers Printing a list of changed prices for review by the receivable Shipment has occurred Immediate online entry into the computer system and department that authorized the changes Control matrix Primary revenue producing activity has been performed immediate assignment of unique identification number Reconciling input with printed output reports to assure Flowchart Mitigating risk that unearned revenues are recorded Reconciliation of shipping records with billing records that all changes were made and no unauthorized ones Documented walkthroughs of processes. Distributing monthly statements to customers, why? Supervisory review, such as review of transactions at a were added Unusual transactions require a high level of management fast-food franchise Limiting authorization privileges to those individuals with review Reconciliation of inventory with sales the responsibility for pricing 13 14 15 16 Explanation of Accounts Receivable Aging and Fraud, Exhibit Check Your Basic Knowledge (9-15) Performing Analytical Procedures on Control Exhibit 9.6 9.6 9-15 Which of the following procedures can organizations use to address Step 1: Identify suitable analytical procedures In thinking about the receivables turnover ratios on the credit risk most effectively? a. An informal credit policy, which may be automated for most Step 2: Evaluate reliability of data used to develop prior slide, consider a typical journal entry for recording transactions, but requires special approval for large and/or unusual expectations fictitious revenue: transactions. Dr. Accounts Receivable b. A periodic review of the credit policy by key executives to Step 3: Develop expectations Cr. Revenue determine whether changes are dictated either by current Step 4 and Step 5: Define and identify significant economic events or by deterioration of the receivables. When will fictitious accounts receivable be collected? unexpected differences The answer? NEVER! c. Periodic monitoring of receivables for evidence of increased risk, such as increases in the number of days past due or an unusually Step 6 and Step 7: Investigate significant unexpected Therefore, accounts receivable balances, ratios, and aging will all be high concentration in a few key customers whose financial differences and ensure proper documentation affected by a revenue cycle fraud involving the recording of fictitious prospects are declining. revenue. d. Adequate segregation of duties over fixed assets, with specific authorization to write off fixed assets that have been fully depreciated. 17 18 19 20 Responding to Identified Risks of Material Check Your Basic Knowledge—True/False Check Your Basic Knowledge (9-19) Check Your Basic Knowledge (9-20) Misstatement 9-17 The auditor might conclude that a heightened risk of fraud 9-19 Which of the following statements is false regarding planning 9-20 Assume that an auditor expected that the client’s activities Develop an audit approach that contains substantive exists if the planning analytical procedures indicate analytical procedures in the revenue cycle? related to sales and accounts receivable would be similar to procedures and, if appropriate tests of controls increases in revenue and net income, but negative cash a. As revenue is typically regarded as a high-risk account, industry averages. Which of the following relationships detected as part of planning analytical procedures would not suggest a Sufficiency and appropriateness of selected procedures will flow from operations. (T/F) planning analytical procedures related to revenue are not vary for each relevant assertion required. heightened risk of material misstatement in the revenue cycle? 9-18 When performing planning analytical procedures, the a. The number of days’ sales in accounts receivable decreased Customize audit program based on assessment of risk of auditor could perform trend analysis with ratios, but not b. The first step in planning analytical procedures includes from 65 days in the prior year to 47 days in the current year. material misstatement with account balances. (T/F) developing an expectation of recorded amounts or ratios, and evaluating whether that expectation is precise enough to The industry average increased from 45 to 47 days. accomplish the relevant objective. b. The gross margin increased from 16.7% to 18.3%, while the industry average changed from 16.7% to 16.3%. c. Trend analysis would not be appropriate as a planning analytical procedure in the revenue cycle. c. Accounts receivable increased 35% over the prior year, while sales stayed relatively stable. d. All of the above statements are false. d. All of the above relationships are suggestive of a heightened risk of fraud. 21 22 23 24 Exhibit 9.7 Check Your Basic Knowledge—True/False Check Your Basic Knowledge (9-23) Check Your Basic Knowledge (9-24) 9-21 Responding to identified risks in the revenue cycle rarely 9-23 After identifying the risks of material misstatement, the auditor 9-24 Responding to identified risks involves developing an audit involves developing an audit approach that contains develops an audit plan in response to those risks. Which of the approach that addresses those risks. Which of the following substantive procedures (e.g., tests of details and, when following plans for testing revenue would be most likely when statements about the planned audit approach is true for the appropriate, substantive analytical procedures). (T/F) the auditor believes that control risk is high? revenue cycle?