61 medium explain why it is necessary to allocate the

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Unformatted text preview: sheet than income statement accounts. 62. medium Why do most practitioners allocate the preliminary judgment about materiality to balance sheet accounts? Answer: Most income statement misstatements have an equal effect on the balance sheet because of the double-entry bookkeeping system. Because there are fewer balance sheet accounts than income statement accounts in most audits and most audit procedures focus on balance sheet accounts, allocating materiality to balance sheet accounts is the most appropriate alternative. 63. medium Discuss how auditors use the audit risk model when planning an audit. Answer: The audit risk model is used primarily for planning purposes in deciding how much evidence to accumulate in each 1-169 cycle. The auditor decides an acceptable level of audit risk, assesses inherent risk and control risk, and then uses the relationship depicted in the following model to determine an appropriate level for planned detection risk: PDR 64. medium = AAR IR x CR Describe the audit risk model and each of its components. Answer: The planning form of the audit risk model is stated as follows: PDR where: = PDR AAR IR CR AAR IR x CR = = = = planned detection risk acceptable audit risk inherent risk control risk Planned detection risk is a measure of the risk that audit evidence for an account will fail to detect misstatements exceeding a tolerable amount, should such misstatements exist. Planned detection risk determines the amount of substantive evidence that the auditor plans to accumulate. Acceptable audit risk is a measure of how willing the auditor is to accept that the financial statements may be materially misstated after the audit is completed and an unqualified opinion has been issued. It is influenced primarily by the degree to which external users will rely on the statements, the likelihood that a client will have financial difficulties after the audit report is issued, and the auditor’s evaluation of management’s integrity. Inherent risk is a measure of the auditor’s assessment of the likelihood that there are material misstatements in an account before considering the effectiveness of internal control. Control risk is a measure of the auditor’s assessment of the likelihood that misstatements exceeding a tolerable amount in an account will not be prevented or detected by the client’s internal controls. 65. medium There are several factors that affect an audit firm’s business risk and, therefore, acceptable audit risk. Discuss three of these factors. Answer: Business risk and acceptable audit risk are affected by: 1-170 • • • The degree to which external users will rely on the statements . For large, publicly held clients, business risk is greater, and acceptable audit risk will be less, than for small, privately held clients, all things being equal. The likelihood that a client will have financial difficulties after the audit report is issued. Business risk is greater, and acceptable audit risk will be lower, when the client is experiencing financial difficulties. The auditor’s evaluation of management’s integrity . Business risk is greater and acceptable audit risk will be lower when the client’s management has questionable integrity. 1-171 66. challenging Discuss each of the five steps in applying materiality in an audit, and identify the audit phase(s) in which each step is performed. List these steps in the order in which they occur. Answer: Step 1. Set preliminary judgment about materiality . This is the combined amount of misstatements in the financial statements that would be considered material. This decision is made in the planning stage of the audit. Step 2. Allocate preliminary judgment about materiality to segments . In this step, the auditor normally allocates the preliminary judgment about materiality to the balance sheet accounts. The amount of materiality allocated to an account is referred to as that account’s tolerable misstatement. This allocation is performed in the audit planning stage. Step 3. Estimate total misstatement in segment. In this step, the auditor projects the sample results to the population. An allowance for sampling risk is also calculated. This would be performed after the substantive tests for each account are completed. Step 4. Estimate the combined misstatement . In this step, the projected errors for each account are added, along with total sampling error, to calculate the combined misstatement. This would be performed after all substantive tests have been completed. Step 5. Compare combined estimated misstatement with preliminary or revised judgment about materiality. If the combined estimated misstatement is less than or equal to the judgment about materiality, then the auditor concludes the financial statements are fairly presented. This would be performed after all substantive tests have been completed, in the final review stage of the audit. Other Objective Answer Format Questions 67. easy Below are four situations that involve the audit risk model as it is used for...
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This note was uploaded on 02/04/2014 for the course ACCOUNTING 211 taught by Professor Alikapur during the Fall '13 term at American University of Sharjah.

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