MODULE 2 AUDIT PLANNING

Posttest

1. Define the following terms:

a. audit risk – refers to the possibility that the auditors fail to appropriately
modify their opinion on financial statements that are materially misstated.
b. inherent risk – the susceptibility of a financial statement assertion to a
material misstatement, assuming there are no related internal control.
c. control risk – the risk that a material misstatement could occur in a
financial statements assertion and not be prevented or detected by the
client’s internal control.
d. detection risk – the risk that the audit procedures will not detect a material
misstatement in a financial statement assertion.

2. How does audit planning assist in assessing inherent risk?

In audit planning, the auditor considers what would make the financial statements
materially misstated. The auditor’s assessment of materiality helps the auditor
decide questions as to what items to examine, the option to use sampling and
analytic procedures. This enables the auditor to select audit procedures that can be
expected to reduce the audit risk to an acceptably low level.

3. Name three sources of business and industry information.

 Previous experience with the entity and its industry
 Discussion with people with the entity (for example, directors and senior
operating personnel)
 Discussion with internal audit personnel and review of internal audit reports

4. What is the audit risk model?

a. How can an auditor use the audit risk model?
The audit risk model determines the total amount of risk associated with an
audit, and describes how this risk can be managed. Audit risk may be
considered as the product of the various risks which may be encountered in
the performance of the audit. In order to keep the overall audit risk of
engagements below acceptable limit, the auditor must assess the level of risk
pertaining to each component of audit risk.

Audit Risk = Inherent Risk x Control Risk x Detection Risk

Auditors proceed by examining the inherent and control risks pertaining to an

audit engagement while gaining an understanding of the entity and its
environment. Detection risks forms the residual risk after taking into
consideration the inherent and control risks that the auditor is willing to
accept. Where the auditor’s assessment of inherent and control risk is high,
the detection risk is set at a lower level to keep the audit risk at an
acceptable level. Lower detection risk may be achieved by increasing the
sample size for audit testing. Conversely, where the auditor believes the
inherent and control risks of an engagement to be low, detection risk is
allowed to be set at a relatively higher level.

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 5. Describe the relationship between detection risk and evidence accumulation.
Detection risk is the risk that the auditors fails to detect a material misstatements in
the financial misstatements. Detection risk can be reduced by auditors by
increasing the number of sampled transactions for detailed testing thus increasing
evidence accumulation.

6. Analytical procedures consist of evaluations of financial information made by a

study of plausible relationships among both financial and nonfinancial data. They
range from simple comparisons to the use of complex models involving many
relationships and elements of data. They involve comparisons of recorded amounts,
or ratios developed from recorded amounts, to expectations developed by the
auditors.
Required:
a. Describe the broad purpose of analytical procedures.
 To assist the auditor in planning the nature, timing, and extent of other
auditing procedures
 As a substantive test to obtain evidential matter about particular
assertions related to account balances or classes of transactions
 As an overall review of the financial information in the final review
stage of the audit.

b. Identify the sources of information from which an auditor develops

expectations.
 Financial information for comparable prior periods giving consideration
to known changes
 Anticipated results – for example budgets or forecasts
 Relationships among elements of financial information within the
period
 Information regarding the industry in which the client operates – for
example, gross margin information
 Relationships of financial information with relevant non-financial
information.

c. Describe the factors that influence an auditor's consideration of the reliability

of data for purposes of achieving audit objectives.
In deciding whether to reduce the amount of testing for specific assertions
because of work performed by internal auditors, the independent auditor
should consider:
 The materiality of the amount
 The risk of misstatement
 The degree of subjectivity involved in evaluating the accumulated
audit evidence

(AICPA Adapted)
7. The following questions deal with materiality. Choose the best response.

A. Which one of the following statements is correct concerning the concept of

materiality?

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 a. Materiality is determined by reference to guidelines established by the
AICPA.
b. Materiality depends only on the peso amount of an item relative to other
items in the financial statements.
c. Materiality depends on the nature of an item rather than peso amount
d. Materiality is a matter of professional judgment.

B. The concept of materiality will be at least important to the CPA in

determining the
a. scope of his audit of specific accounts.'
b. specific transactions that should be reviewed.*
c. effects of audit exceptions upon his opinion. *
d. effects of his direct financial interest in a client upon his independence.

8. The following questions concern materiality and risk. Choose the best response.

A. Edison Corporation has a few large accounts receivable that total PI.400,
000. Victor Corporation has a great number of small accounts receivable that
also total PI, 400,000. The importance of an error in any one account is,
therefore, greater for Edison than for Victor. This is an example of the
auditor's concept of:
a. materiality.
b. comparative analysis.
c. reasonable assurance.
d. relative risk.

B. Which of the following elements ultimately determines the specific auditing

procedures that are necessary in the circumstances to afford a reasonable
basis for an opinion?
a. Auditor judgment
b. Materiality
c. Relative risk
d. Reasonable assurance

C. Which of the following best describes the element of relative risk that
underlies the application of generally accepted auditing standards,
particularly the standards of field work and reporting?
a. Cash audit work may have to be carried out in a more conclusive manner
than inventory audit work.
b. Intercompany transactions^^ usually subject to less detailed scrutiny than
arm's-length transactions with outside parties.
c. Inventories may require more attention on an engagement for a public
utility.
d. The scope of the examination need not be expanded if errors that arouse
suspicion of fraud are of relatively insignificant amounts.

9. The following questions deal with materiality and risk, and their effect on audit
reports. Choose the best response.

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 A. A major customer of an audit client suffers a fire just prior to completion of
year-end field work. The audit client believes that this event could have a
significant direct effect on the financial statements. The auditor should:
a. advise management to disclose the event in notes to the financial
statements.
b. disclose the event in the auditor's report.
c. withhold submission of the auditor's report until the extent of the direct
effect on the financial statements is known.
d. advise management to adjust the financial statements.

B. Late in December, Tech Products Company sold its marketable securities

that had appreciated in value and then repurchased them the same day. The
sale and purchase transactions resulted in a large gain. Without the gain the
company would have reported a loss for the year. Which of the following
statements with respect to the auditor is correct?
a. If the sale and repurchase are disclosed, an unqualified opinion should be
rendered.
b. The repurchase transaction is a sham and the auditor should insist upon a
reversal or issue an adverse opinion.
c. The auditor should withdraw from the engagement and refuse to be
associated with the company.
d. A disclaimer of opinion should be issued.

C. A material change in an accounting estimate

a. requires a consistency modification in the auditor's report and disclosure in
the financial statements.
b. requires a consistency modification in the auditor's report but does not
require disclosure in the financial statements.
c. affects comparability and may require disclosure in a note to the financial
statements but does not require a consistency modification in the auditor's
report,
d. involves the acceptability of the generally acceptable accounting principles
used.

10. Below are an auditor's planned audit risk and assessment of inherent risk and
control risk for five situations.

Planned Audit Assessed Inherent Assessed

Situation
Risk Risk Control Risk
1 1% 20% 20%
2 1 100 50
3 4 20 20
4 5 100 50
5 5 100 100
Required:
a. Determine the detection risk that can be allowed for each situation.
Audit Risk = Inherent Risk x Control Risk x Detection Risk
Situation Detection
Risk
1 25 %

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 2 2%
3 100 %
4 10 %
5 5%

b. Rank the five situations, based on the amount of audit evidence that will be
needed. You may assume that all other factors that may affect audit evidence
accumulation are the same.
Rank Situatio Detection Risk
n
2 1 25 %
5 2 2%
1 3 100 %
3 4 10 %
4 5 5%

11. Audit risk and materiality should be considered when planning and performing
an audit in accordance with GAAS. Both audit risk and materiality should also be
considered in determining the nature, timing, and extent of auditing procedures
and in evaluating the results of those procedures.

Required:
A.
a. Define audit risk.
Refers to the possibility that the auditors fail to appropriately modify their
opinion on financial statements that are materially misstated.
b. Describe is components of inherent risk, control risk, and detection risk.
Inherent Risk – It is the risk of a material misstatement in the financial
statements arising due to error or omission as a result of factors other than the
failure of controls.
Control Risk – It is the risk of a material misstatement in the financial
statements arising due to absence or failure in the operation of relevant
controls of the entity.
Detection Risk – it is the risk that the auditors fail to detect a material
misstatement in the financial statements.
c. Explain how these components are interrelated.
Where the auditor’s assessment of inherent and control risk is high, the
detection risk is set at a lower level to keep the audit at an acceptable level.
Lower detection risk may be achieved by increasing the sample size for audit
testing. Conversely, where the auditor believes that inherit and control risks of
an engagement to be low, detection risk is allowed to be set at a relatively
higher level.
B.
a. Define materiality – “omissions or misstatements of items are material if they
could, individually or collectively, influence the economic decisions of users
taken on the basis of the financial statements.
b. Discuss the factors affecting its determination. – The factors that affects the
determination of materiality is that it should have an impact on the decision

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 making of users. It size and nature or combination of both could also be a
determining factors. Both the amount (quantity) and nature (quality) of
misstatements need to be considered. Examples of qualitative misstatements
would be the inadequate or improper description of an accounting policy when
it is likely that a user of the financial statements would be misled by the
description.

12. Last year you were assigned to minor parts of the audit of the sales and
collections cycle for Patrick Corporation. This year you have been assigned
significant responsibility in the audit of the sales and collections cycle. You recall
that last year, the credit manager, Josie Tan, treated you as if you were one of the
clerks. In fact, you had to call her "Ms. Tan" when you went to ask her several
questions. This year, she has become very friendly. Josie, as she now wants you
to call her, has just invited you to join her for dinner at a very exclusive private
club in town. You were called away before you could give Josie a reply, but she did
indicate to you that last year she took your predecessor to such a dinner.

Required: How do you respond to Josie?

The primary issue raised here is how friendly an auditor should be with a client
personnel. This situation is especially interesting in light of the auditor’s view of the
relationship prior to being assigned significant responsibility. The issue is whether
Josie is trying to become friendly in order to try to manipulate the auditor’s
decisions.

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