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Unformatted text preview: Chapter 05 - Audit Evidence and Documentation CHAPTER 5 Audit Evidence and Documentation Review Questions 5-1 Audit risk is the possibility that the auditors may unknowingly fail to appropriately modify their opinion on financial statements that are materially misstated. It is composed of the possibility that (1) a material misstatement in an assertion about an account has occurred (inherent risk and control risk), and (2) the auditors do not detect the misstatement (detection risk). Detection risk is this second component, the 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. All other factors held constant, audit risk increases with increases in detection risk. 5-2 The two components of the risk of material misstatement include inherent risk and control risk. Inherent risk is the risk of material misstatement of an assertion about an account, class of transaction, or disclosure without considering internal control, and control risk is the risk that internal control will fail to prevent or detect and correct the material misstatement. 5-3 Inherent risk refers to the possibility of a material misstatement occurring in an assertion assuming no related internal controls. Accordingly, since it exists independently of the auditors, the auditors cannot reduce inherent risk. Rather, they gather evidence that allows them to make an accurate assessment of the existing inherent risk. 5-4 Routine transactions involve recurring financial activities recorded in the accounting records in the normal course of business. Examples include sales transactions, purchase transactions, cash disbursements, cash receipts, and payroll transactions. Nonroutine transactions involve activities that occur only periodically. Examples include taking physical inventories, calculating depreciation, and consolidating financial results. Estimation transactions are financial reporting activities that involve creating an accounting estimate. Examples include estimating the allowance for uncollectible accounts, estimating warranty reserves, and assessing assets for impairment. 5-5 Because inherent risk and control risk are a result of characteristics of the client and its internal controls, auditors assess them. Because detection risk is a function of the effectiveness of the audit procedures used to gather evidence, it is restricted to the appropriate level based on the scope of procedures performed. 73 Chapter 05 - Audit Evidence and Documentation 5-6 The sufficiency of audit evidence is a matter of judgment on every audit, because there are no firm guidelines on the quantity of evidence necessary in a specific audit. The strength of the client's internal control, the inherent risk of the audit, the levels of materiality for the audit, and the existence of related-party transactions are among the factors influencing the auditors' judgment on the sufficiency of audit evidence. the sufficiency of audit evidence....
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- Spring '11