Deck 10: Evidence About Management Assertions: Linking Residual Risks to Substantive Tests

Question 1

Why are the motivations of management a critical element of assessing inherent risk?

Answer 1

Management may desire to increase profits so that the market value of the company's stock increases, maximizing the value of management's stock options more valuable. The mere presence of a stock option plan is not bad; indeed, most public companies have them, but the risks deepen if an inappropriate mix of compensation is offered such that management is induced to artificially overstate profits. Therefore, the auditor needs a deeper understanding of management's attitudes towards artificially boosting profits. The inherent risk of the engagement depends on whether management attempts to cash in on the options by manipulating accounting results. Similarly, a small, family-owned, business might have owners who are interested in keeping profits low so that the company can minimize its tax bill. In this situation, the auditor must then be aware of the potential motivation to intentionally understate income.
The fear of violating a loan covenant restrictions, which involve accounting based numbers, might motivate management the change the accounting in order to avoid technical default which could enable the creditor to gain legal influence over the company.

Question 2

Using the audit risk model, describe how the risk of material misstatement impacts detection risk.

Answer 2

a. The audit risk model relates the components to overall audit risk as follows:
i) AR = RMM x DR
AR=audit risk, RMM=risk of material misstatement, DR=detection risk.
ii) The two interrelated components of RMM (inherent and control risk) can be substituted into the model:
b. AR = (IR x CR) x DR
i) IR = inherent risk, CR = control risk.
(1) The components of audit risk focus on management assertions.
(2) Therefore, RMM impacts DR because the nature and extent of substantive tests performed by the auditor are driven by assessments of IR and CR.

Question 3

Explain detection risk.

Answer 3

Detection risk is the risk that the auditor will not detect a material misstatement that exists in the financial statements or more specifically in a financial statement assertion after considering existing internal controls. This risk can be traced to the failure of substantive tests. An auditor may fail to detect an existing misstatement in the financial statements for a number of reasons.

Question 4

Describe qualitative factors that may be important when setting the overall level for planning materiality.

Question 5

Describe the three events that must happen, according to the audit risk model, for a material misstatement to affect the financial statements.

Question 6

Describe five ways a residual risk can impact an audit.

Question 7

Describe the risk of material misstatement, and describe how this risk applies at the assertion level.

Question 8

When the auditor needs additional evidence to verify specific assertions or disclosures, what are the types of analytical procedures the auditor may choose and what factors affect the choice?

Question 9

Define and explain audit risk.

Question 10

What is the problem with the (formerly common) practice among auditors to not correct a detected misstatement because the amount in question was not considered material?

Question 11

Describe factors that will influence the auditor's decision in setting audit risk.

Question 12

What four potential problems are related to the level of detection risk for any specific assertion?

Question 13

What is inherent risk?

Question 14

Explain, in general, how the auditor chooses (in percentage) audit risk in the audit.

Question 15

Explain control risk.

Question 16

Describe the only component of the audit risk model that is actually under the control of the auditor.

Question 17

Describe the appropriate use of the audit risk model.

Question 18

What does the audit risk model tells us about the relationship between detection risk and audit risk and, similarly, the relationship between detection risk and the risk of material misstatement?

Question 19

Describe characteristics that the auditor can consider in order to understand the appropriateness of evidence.

Question 20

Describe the auditor's use of tolerable error.

Question 21

What are the features of a high-quality audit program for substantive testing?