Term
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Definition
| The magnitude of an omission or misstatement of accounting information that makes it PROBABLE that the judgment of a reasonable person relying on the information would have been changed or influence by the omission or misstatement |
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Term
| What are the Steps in Applying Materiality |
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Definition
i.Set preliminary judgment about materiality
ii.Allocate preliminary judgment about materiality to segments
iii.Estimate total misstatement in segment
iv.Estimate the combined misstatement
v.Compare combined estimate with preliminary or revised judgment about materiality |
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Term
| What are the differences between steps 1 & 2 and 3-5 of the steps in applying materiality |
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Definition
1.Steps 1 &2= Planning extent of tests
2.Steps 3-5= Evaluating results |
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Term
| What does a low level of materiality mean in terms of work, conservatism and concern? |
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Definition
| More work, being more conservative, more concerns |
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Term
| WHat does a high level of materiality mean in terms of work, conservatism and concern? |
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Definition
| less work, less conservative, less concern....can tolerate more errors |
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Term
| Define Step #1- Preliminary Judgment about materiality |
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Definition
| the maximum amount by which the auditor believes the statements could be misstated and still NOT AFFECT the decisions of reasonable users ($1 less than materiality) |
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Term
| Why do auditors set a preliminary judgment about materiality |
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Definition
| to help plan the appropriate evidence to accumulate |
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Term
| What is a revised judgment about materiality |
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Definition
| a revision to the primary judgment about materiality that is often made during the course of the audit |
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Term
| What are the factors that affect the auditor’s preliminary judgment about materiality |
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Definition
i.Materiality is a relative rather than an absolute concept
ii.Bases are needed for evaluating materiality (Quantitative)
iii.Qualitative Factors |
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Term
| What does "relative rather than absolute" mean? |
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Definition
| What is material for one company will not necessarily be material for another |
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Term
| What is the base needed for evaluating materiality? |
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Definition
| Net income before taxes is often the primary base |
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Term
| What will qualitative factors most likely do to materiality |
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Definition
| Most likely will decrease materiality= more evidence needed |
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Term
| What are some examples of qualitiative factors that affect materiality |
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Definition
a.Amounts involving fraud > unintentional errors
b.Minor misstatements become material if possible consequences arise from contractual obligations (notes, other covenants)
c.Minor misstatements may become material if they affect a trend in earnings |
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Term
| What is Tolerable misstatement? |
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Definition
| the materiality allocated to any given account balance- The account balance would be fairly stated if it is misstated by this amount or less |
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Term
| Will tolerable error will always be more or less than materiality? |
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Definition
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Term
| What kind of accounts do auditors allocate materiality to? |
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Definition
| B/S rather than income statement due to the nature of the double entry accounting system |
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Term
| What are the 3 major difficulties in allocating materiality to B/S accounts |
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Definition
i.Auditors expect certain accounts to have more misstatements than others
ii.Both over/under statements must be considered
iii.Relative audit costs affect the allocation |
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Term
| What are the tendencies of misstatements with assets and liabilities? |
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Definition
| Liabilities are more likely to be understated and assets more likely to be overstated |
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Term
| What are the accounts that have low tolerable misstatements? |
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Definition
i.Notes payable
ii.Accrued interest and dividends payable
iii.Capital stock and capital in excess of par |
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Term
| What are the requirements of allocating tolerable misstatement? |
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Definition
i. Tolerable misstatement for any accounts cannot exceed x % of the preliminary judgment
ii.The sum of all tolerable misstatements cannot exceed twice the preliminary judgment about materiality |
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Term
| Why is that tolerable misstatement for any accounts cannot exceed x% of the preliminary judgment? |
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Definition
a.Not acceptable to have such a large misstatement in one account
b.Does not allow for any misstatements in other accounts |
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Term
| Why is it that the sum of all tolerable misstatements cannot exceed twice the preliminary judgment about materiality? |
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Definition
a. Unlikely that all accounts will be misstated by the full amount of tolerable misstatement
b. Some accounts are likely to be overstated , whereas others are likely to be understated |
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Term
| WHat are the two types of misstatements that can be in any account? |
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Definition
| known misstatements, likely misstatments |
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Term
| What is a known misstatements? |
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Definition
| a misstatement where the auditor can determine the amount of the misstatement in the account |
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Term
| What is an example of a known misstatement and which account is almost always "known" |
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Definition
Something that was capitalized that should be expensed
Often cash account will be known rather than unknown because we can take the population instead of a sample |
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Term
| What are the two types of likely misstatements? |
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Definition
1. Differences b/t management’s and auditor’s judgment about estimates of account balances
2. Projections of misstatements based on the auditor’s tests of a sample from a population |
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Term
| What are accounts that probably have likely misstatments? |
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Definition
| Often accounts receivable or inventory accounts |
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Term
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Definition
| an error which occurs b/c only a portion of the population has been sampled |
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Term
| What is the formula for direct projection estimate of misstatement? |
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Definition
| (Misstatement in sample/ Total Sampled) x Population |
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Term
| what is the audit risk model? |
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Definition
PDR=AAR/ (IR x CR) or
Planned Detection risk= Acceptable Audit Risk / (Inherent Risk x Control Risk) |
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Term
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Definition
| uncertainty in performing the audit function |
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Term
| What is Planned Detection risk? |
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Definition
| the risk that evidence will NOT detect a material misstatement |
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Term
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Definition
| the amount of substantive evidence that the auditor plans to accumulate |
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Term
| What does it mean if PDR is higher or lower in terms of work and acceptable risk? |
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Definition
1. If the PDR is higher that means less work b/c accepting more risk
2. If the PDR is low that means more work b/c we’re accepting less risk |
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Term
| What is Acceptable audit risk? |
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Definition
| risk that the auditors willing to accept that when the audit is complete there is still a material misstatement in the f/s |
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Term
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Definition
| We are 95% confident that the f/s are fairly stated |
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Term
| Would you assign 5 or 10% to very risky business? What about a very low-risk business? |
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Definition
| Less risky= 10% More risky business= 5% |
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Term
| What does 0% and 100% AAR represent |
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Definition
| absolute certainty and absolute uncertainty |
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Term
| What is audit assurance? What would the audit assurance be for a 5% AAR |
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Definition
| the complement of AAR (one minues AAR) 95% audit assurance |
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Term
| What kind of relationship does AAR have with PDR and Evidence? |
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Definition
| Direct relationship with PDR, inverse relationship with evidence |
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Term
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Definition
| i. Measures the auditor’s assessment of the likelihood that there are material misstatements due to error or fraud in a segment before considering the effectiveness of internal control |
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Term
| What is a factor to be ignored when setting inherent risk? |
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Definition
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Term
| What is inherent risk's relationship to PDR and to evidence? |
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Definition
iii. Inversely related to Planned Detection Risk (when IR goes up PDR goes down and vice versa)
iv. Directly related to Evidence and more experienced staff(when IR goes up planned evidence goes up and experienced staff in that area goes up) |
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Term
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Definition
| risk that managements internal control system will not catch errors in its normal application |
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Term
| What is the risk of material misstatement? |
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Definition
| Control risk x inherent risk |
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Term
| Do we want control risk to be low or high? |
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Definition
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Term
| How does control risk relate to PDR and evidence? |
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Definition
| Varies inversely with PDR and directly with evidence |
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Term
| What is a Compensating control? |
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Definition
| iv. Compensating control- a group will do something other than the internal control if it doesn’t work well |
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Term
| Which cycle is the riskiest cycle in terms of control risk? |
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Definition
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Term
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Definition
| the risk that the auditor or audit firm will suffer harm after the audit is finished, even though the audit report was correct |
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Term
| What is engagement risk closely related to? |
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Definition
| Closely related to client business risk |
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Term
Even though auditors disagree about whether engagement risk should be considered in planning the audit
what is the view of those who think it should be included? |
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Definition
| more work should be done where legal exposure is high which means decreasing AAR |
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Term
| What are the factors Affecting Engagement risk and thus Acceptable Audit Risk (AAR) |
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Definition
1. the degree to which external users rely on statements
2. the likelihood that a client will have financial difficulties after audit report is issued
3. the integrity of management |
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Term
| How is a client's size measured? |
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Definition
| total assets or total revenues, which will decrease AAR |
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Term
| How does distribution of ownership affect engagement risk and thus AAR? |
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Definition
| Publicly help corporations are relied on by more people- will decrease AAR |
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Term
| What are the methods used to assess acceptable audit risk |
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Definition
| Examine financial statements, read minutes of board of directors, examine form 10K, and discuss financing plans of management |
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Term
| What are the factors that affect the degree to which external users rely on statements? |
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Definition
1.Client’s size
2.Distribution of ownership
3.Nature and amount of liabilities |
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Term
| What are the factors that indicate increased probability of financial failure? |
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Definition
a.Liquidity position
b.Profits (losses) in previous years-
c.Method of financing growth
d.Nature of the client’s operations
e.Competence of management |
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Term
| What should happen when the auditor believes the chance of financial failure or loss is high? |
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Definition
| Engagement risk should increase, and AAR should be reduced |
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Term
| WHat are Methods Used to assess acceptable audit risk? |
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Definition
| Analyze financial statements using ratios, examine historical and projected cash flow statements for the nature of cash inflows and outflows |
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Term
| What are examples of questionable management integrity? |
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Definition
a. Criminal conviction
b.Frequent disagreements with previous auditors, IRS, and SEC
c.Frequent turnover of key financial and internal audit personnel
d.Ongoing conflicts with labor unions and employees |
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Term
| What factors should the auditor consider when assessing inherent risk |
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Definition
i. Nature of client’s business
ii. Results of previous audits
iii. Initial versus repeat engagement
iv. Related parties
v. Non-routine transactions
vi. Judgment required to correctly record account balances and transactions
vii. Makeup of the population
viii. Factors related to fraudulent financial reporting and misappropriation of assets |
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Term
| What parts of the audit is inherent risk calcluated for? |
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Definition
| each cycle, account, and audit objective |
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Term
| When do auditors assess inherent risk? |
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Definition
| Auditors begin their assessment of inherent risk during the planning phase and update the assessments throughout the audit |
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Term
| In addition to modifying audit evidence, what are two other ways that auditors can change the audit to respond to risks> |
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Definition
i.The engagement may require more experienced staff
ii.The engagement will be reviewed more carefully that usual |
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Term
| What risks are not assessed for the OVERALL audit? |
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Definition
| control risk, inherent risk |
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Term
| Which risk is held constant for each major cycle and account- for ENTIRE AUDIT |
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Definition
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Term
| What is one major limitation in the application of the audit risk model components of the model and how is it overcome? |
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Definition
| the difficulty of measuring the components of the model. To offset this problem many auditors use broad and subjective measurement terms such as low, medium and high |
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Term
| What is an example of meaningful statement reguarding materiality and risk? |
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Definition
The auditor plans to accumulate evidence such that there is only a 5% risk (acceptable audit risk) of failing to uncover misstatements exceeding tolerable misstatement of 265,000 (materiality).
ii. If a statement eliminate the risk or materiality portion, it’s meaningless |
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Term
| What must be done if the auditor decided that the original assessment of control risk or inherent risk was understated or acceptable audit risk was overstated. |
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Definition
1.Revise the original assessment of the appropriate risk.
2.Consider the effect of the revision on evidence requirements, without use of the audit risk model |
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