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5-1

The possibility that the auditors may
unknowingly fail to appropriately modify their
opinion on financial statements that are
materially misstated


This is the risk that the auditors will issue an
unqualified opinion on financial statements that
contain a material departure from GAAP.
Auditors must obtain sufficient appropriate
audit evidence to reduce audit risk to a low
level in every audit.
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5-2

Relevant assertions are those that, without
regard for controls, have a reasonable
possibility of containing a material
misstatement; types



Assertions about account balances (Accounts)
Assertions about classes of transactions and events
(Transactions)
Assertions about presentation and disclosure
(Disclosures)
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5-3
Accounts
Transactions
Disclosures
Existence
Occurrence
Occurrence
Rights and
obligations
Rights and
obligations
Completeness
Completeness
Completeness
Valuation and
allocation
Accuracy
Accuracy and
valuation
Cutoff
Classification
Classification and
understandability
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5-4






Existence or Occurrence—Assets, liabilities, and equity interests
exist and recorded transactions have occurred
Rights and Obligations—The company holds rights to the
assets, and liability are the obligations of the company
Completeness—All assets, liabilities, equity interests, and
transactions that should have been recorded have been recorded
Cutoff—Transactions and events have been recorded in the
correct accounting period
Valuation, Allocation and Accuracy—All transactions, assets,
liabilities and equity interests are included in the financial
statements at proper amounts
Presentation and Disclosure—Accounts are described and
classified in accordance with generally accepted accounting
principles, and financial statement disclosures are complete,
appropriate, and clearly expressed
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5-5
Audit Risk =
Risk of Material
Misstatement
= Inherent
Risk



Control
Risk
Risk Auditors Fail
to Detect Material
Misstatement
Detection
Risk
Inherent Risk—Risk of a material misstatement occurring in
an assertion assuming no related internal controls.
Control Risk—Risk that a material misstatement in an
assertion will not be prevented or detected on a timely basis
by the company’s internal control.
Detection Risk—Risk that the auditors’ procedures will lead
them to conclude that a material misstatement does not exist
in an assertion when in fact such misstatement does exist.
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5-6
AR = IR * CR * DR
AR
IR
CR
DR
=
=
=
=
Audit risk
Inherent risk
Control risk
Detection risk
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5-7
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5-8


Factors that affect inherent risk:
 Nature of the client and its environment
 Nature of the particular financial statement element
Business characteristics indicative of high inherent risk:





Inconsistent profitability of client
Operating results highly sensitive to economic factors
Going concern problems
Large known and likely misstatements detected in prior audits
Substantial turnover, questionable reputation, or inadequate
accounting skills of management
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5-9

Involve:
Difficult to audit transactions or balances
 Complex calculations
 Difficult accounting issues
 Significant judgment by management
 Valuations that vary significantly based on economic
factors

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5-10

Routine



Nonroutine



Recurring financial statement activities recorded in the
accounting records in the normal course of business
Lower inherent risk
Involve activities that occur only periodically such as the taking
of physical inventories
High inherent risk
Estimation transactions


Activities that create accounting estimates
Higher inherent risk
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5-11
Auditor must obtain sufficient appropriate audit
evidence.
 To be appropriate audit evidence must be:



Relevant
Reliable

Obtained from knowledgeable independent sources
outside the company rather than nonindependent sources
Generated internally through a system of effective controls
rather than ineffective controls.
Obtained directly by the auditor rather than indirectly or
by inference
Documentary in form rather than oral
Provided by original documents rather than copies
Principles—Audit evidence is ordinarily more
reliable when it is




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5-12

Risk assessment procedures


To obtain an understanding of the client and its
environment, including its internal control, to
assess the risks of material misstatement
Further Audit Procedures

Tests of controls
 When appropriate, to test the operating effectiveness of controls
in preventing material misstatements

Substantive procedures
 To detect material misstatements at relevant assertion level.
Substantive procedures include (a) analytical procedures, (b) tests
of details of account balances, transactions and disclosures
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5-13
1.
2.
3.
4.
5.
6.
7.
8.
Inspection of records and documents
Inquiry of knowledgeable persons within or
outside the entity
External confirmation
Inspection of tangible assets
Observation of processes or procedures being
performed by others
Recalculation of mathematical accuracy.
Reperformance of procedures
Analytical procedures
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5-14
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5-15


Analytical procedures
Tests of details
 Tests of account balances
 Tests of classes of transactions
 Tests of disclosures

One may change the scope of audit procedures by
changing the (NTE, or re-ordered as NET):
 Nature (type and form)
 Timing (when performed)
 Extent (quantity of evidence obtained)
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5-16
Holding the extent of procedures constant, one
may increase the scope of procedures (make
them more effective) by either changing the

Nature—obtain more reliable evidence
 often externally generated evidence.

Timing—wait until year-end to obtain evidence from
entire set of transactions as contrasted to performing
interim testing, say two months prior to year-end
and simply updating those procedures.
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5-17
Holding other factors such as the nature and
timing of procedures constant:



The greater the risk of material misstatement, the
greater the needed extent of substantive procedures
The main way to increase the extent of audit
procedures is to examine more items
Sample sizes should reduce detection risk so as to
restrict audit risk to a low level
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5-18

Timing of analytical procedures




Risk assessment (sometimes referred to as planning
analytical procedures)
Substantive procedures
Final review
Steps involved




Develop expectation of account (or ratio) balance
Determine amount of difference that can be accepted without
investigation
Compare the company’s account (ratio) with the expectation
Investigate and evaluate significant differences
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5-19

Developing an expectation





Prior period information
Anticipated results
Relationships among elements of financial information within a
period
Industry information
Relationships between financial information and relevant
nonfinancial data.
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5-20

Types of Expectations
 Trend analysis—analyze changes in accounts of a
company over time
 Ratio analysis — compare relationships between two
or more financial statement accounts or comparisons
of account balances to nonfinancial data
 Liquidity (e.g., current ratio)
 Leverage (e.g., debt to equity)
 Profitability (e.g., gross profit percentage)
 Activity (e.g., inventory turnover)
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5-21

Approaches to ratio analysis

Horizontal analysis
 Review ratios over time

Cross sectional analysis
 Analyze ratios of similar firms at a point in time

Vertical analysis
 Analyze relationships within a period
 “Common size” statements prepared

Other methods
 Regression analysis, reasonableness test
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5-22
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5-23



Review and test management’s process
for developing the estimate.
Independently develop an estimate to
compare to management’s estimate.
Review subsequent events or
transactions bearing on the estimate.
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5-24

Inputs to use in applying valuation techniques (FAS 157)
 Level 1 – inputs of observable quoted prices in active
markets for identical assets or liabilities
 Ex. A closing stock price in WSJ

Level 2 – inputs of observable quoted prices, generally
for similar assets or liabilities in active markets
 Ex. Company discounts future cash flows on its not publicly
traded debt securities at rate used by market for publicly
traded debt securities

Level 3 – inputs that are unobservable for the assets or
liability
 Ex. A private company uses judgment to determine a proper rate to discount
the future cash flows of its not publicly traded securities
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5-25


Disclosure requirements must be met
Primary challenge is identifying undisclosed
related party transactions

Determine related parties
 Inquiries of management
 Review SEC filings, stockholder’s listings and conflict-
of-interest statements

Be alert for transactions with related parties and any
transactions with unusual terms
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5-26

Primary functions:
•Support the
auditors’ compliance with auditing
standards
•Support the auditors’ opinion

Secondary functions:
•Assist continuing
and new audit team members in
planning and performing the audit
•Serves as a record of matters of continuing audit interest
•Assists in supervision and review of the audit
•Demonstrates the accountability of team members
•Assists internal reviewers, external peer reviewers,
PCAOB inspectors, and successor auditors in performing
their roles
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5-27

Audit documentation should be sufficient
to:
Enable an experienced auditor to understand the
work performed and the significant conclusions
reached
 Identify who performed and reviewed the work
 Show that the accounting agree or reconcile to
the financial statements


Audit documentation should include all
significant audit findings and the actions
taken to address them
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5-28









Audit administrative working papers
Working trial balance
Lead schedules
Adjusting journal entries and reclassification
entries
Supporting schedules
Analysis of a ledger account
Reconciliations
Computational working papers
Corroborating documents
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5-29

Current files



Current year working papers
Index and cross-referencing
Permanent files

Items of continuing audit interest
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5-30
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5-31
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