©McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom.

No reproduction or further
distribution permitted without the prior written consent of McGraw-Hill Education. 5-1
 The possibility that the auditors may
unknowingly fail to appropriately modify
their opinion on financial statements that are
materially misstated.
 This is the risk that the auditors will issue an
unqualified opinion on financial statements that
contain a material departure from GAAP.
 Auditors must obtain sufficient appropriate
audit evidence to reduce audit risk to a low
level in every audit.

©McGraw-Hill Education. 5-2

 Relevant assertions are those that, without regard
for controls, have a reasonable possibility of
containing a material misstatement; types
 Assertions about account balances (Accounts)
 Assertions about classes of transactions and events
(Transactions)
 Assertions about presentation and disclosure
(Disclosures)

©McGraw-Hill Education. 5-3

Accounts Transactions Disclosures
Existence Occurrence Occurrence
Rights and Rights and
obligations obligations
Completeness Completeness Completeness
Valuation and Accuracy Accuracy and
allocation valuation
Cutoff
Classification Classification and
understandability

©McGraw-Hill Education. 5-4

 Existence or Occurrence—Assets, liabilities, and equity interests
exist and recorded transactions have occurred
 Rights and Obligations—The company holds rights to the
assets, while liabilities are the obligations of the company
 Completeness—All assets, liabilities, equity interests, and
transactions that should have been recorded have been recorded
 Cutoff—Transactions and events have been recorded in the
correct accounting period
 Valuation, Allocation, and Accuracy—All transactions, assets,
liabilities, and equity interests are included in the financial
statements at proper amounts
 Presentation and Disclosure—Accounts are described and
classified in accordance with generally accepted accounting
principles, and financial statement disclosures are complete,
appropriate, and clearly expressed

©McGraw-Hill Education. 5-5

 Risk of Material Risk Auditors Fail
Audit Risk = Misstatement to Detect Material
Misstatement

= Inherent Control Detection

Risk Risk Risk
 Inherent Risk—Risk of a material misstatement occurring in
an assertion assuming no related internal controls.
 Control Risk—Risk that a material misstatement in an
assertion will not be prevented or detected on a timely basis
by the company’s internal control.
 Detection Risk—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.

©McGraw-Hill Education. 5-6

 AR = IR * CR * DR

AR = Audit risk
IR = Inherent risk
CR = Control risk
DR = Detection risk

©McGraw-Hill Education. 5-7

©McGraw-Hill Education. 5-8
 Factors that affect inherent risk:
 Nature of the client and its environment
 Nature of the particular financial statement element
 Business characteristics indicative of high inherent risk:
 Inconsistent profitability of client
 Operating results highly sensitive to economic factors
 Going concern problems
 Large known and likely misstatements detected in prior audits
 Substantial turnover, questionable reputation, or inadequate
accounting skills of the accounting department

©McGraw-Hill Education. 5-9

 Involve:
 Difficult-to-audit transactions or balances
 Complex calculations
 Difficult accounting issues
 Significant judgment by management
 Valuations that vary significantly based on economic
factors

©McGraw-Hill Education. 5-10

 Routine
 Recurring financial statement activities recorded in the
accounting records in the normal course of business
 Lower inherent risk
 Nonroutine
 Involve activities that occur only periodically such as the
taking of physical inventories
 High inherent risk
 Estimation transactions
 Activities that create accounting estimates
 Higher inherent risk

©McGraw-Hill Education. 5-11

Auditor must obtain sufficient appropriate audit evidence.
 To be appropriate audit evidence must be:
 Relevant
 Reliable
 Principles—Audit evidence is ordinarily more reliable
when it is
 Obtained from knowledgeable independent sources outside the
company rather than nonindependent sources
 Generated internally through a system of effective controls rather
than ineffective controls.
 Obtained directly by the auditor rather than indirectly or by
inference
 Documentary in form rather than oral
 Provided by original documents rather than copies

©McGraw-Hill Education. 5-12

 Risk assessment procedures
 To obtain an understanding of the client and its
environment, including its internal control, to assess the
risks of material misstatement
 Further Audit Procedures
 Tests of controls
 When appropriate, to test the operating effectiveness of controls in
preventing material misstatements
 Substantive procedures
 To detect material misstatements at relevant assertion level. Substantive
procedures include (a) analytical procedures, (b) tests of details of
account balances, transactions, and disclosures

©McGraw-Hill Education. 5-13

1. Inspection of records and documents
2. Inquiry of knowledgeable persons within or outside
the entity
3. External confirmation
4. Inspection of tangible assets
5. Observation of processes or procedures being
performed by others
6. Recalculation of mathematical accuracy
7. Reperformance of procedures
8. Analytical procedures

©McGraw-Hill Education. 5-14

©McGraw-Hill Education. 5-15
 Analytical procedures
 Tests of details
 Tests of account balances
 Tests of classes of transactions
 Tests of disclosures
 One may change the scope of audit procedures by
changing the (NTE, or re-ordered as NET):
 Nature (type and form)
 Timing (when performed)
 Extent (quantity of evidence obtained)

©McGraw-Hill Education. 5-16

Holding the extent of procedures constant, one
may increase the scope of procedures (make them
more effective) by either changing the
 Nature—obtain more reliable evidence
 often externally generated evidence.
 Timing—wait until year-end to obtain evidence from
entire set of transactions as contrasted to performing
interim testing, say two months prior to year-end and
simply updating those procedures.

©McGraw-Hill Education. 5-17

Holding other factors such as the nature and
timing of procedures constant:
 The greater the risk of material misstatement, the
greater the needed extent of substantive procedures
 The main way to increase the extent of audit
procedures is to examine more items
 Sample sizes should reduce detection risk so as to
restrict audit risk to a low level

©McGraw-Hill Education. 5-18

 Timing of analytical procedures
 Risk assessment (sometimes referred to as planning
analytical procedures)
 Substantive procedures
 Final review

 Steps involved
 Develop expectation of account (or ratio) balance
 Determine amount of difference that can be accepted without
investigation
 Compare the company’s account (ratio) with the expectation
 Investigate and evaluate significant differences

©McGraw-Hill Education. 5-19

 Developing an expectation
 Prior period information
 Anticipated results
 Relationships among elements of financial information within a
period
 Industry information
 Relationships between financial information and relevant
nonfinancial data

©McGraw-Hill Education. 5-20

 Types of Expectations
 Trend analysis—analyze changes in accounts of a
company over time
 Ratio analysis — compare relationships between two
or more financial statement accounts or comparisons
of account balances to nonfinancial data
 Liquidity (e.g., current ratio)
 Leverage (e.g., debt to equity)
 Profitability (e.g., gross profit percentage)
 Activity (e.g., inventory turnover)

©McGraw-Hill Education. 5-21

 Approaches to ratio analysis
 Horizontal analysis
 Review ratios over time
 Cross sectional analysis
 Analyze ratios of similar firms at a point in time
 Vertical analysis
 Analyze relationships within a period
 “Common size” statements prepared
 Other methods
 Regression analysis, reasonableness test

©McGraw-Hill Education. 5-22

©McGraw-Hill Education. 5-23
December 31 credit sale (real or fraudulent)

Ratio of Sales to AR shortly before year-end:

$700,000 / $100,000 = 7.00

Recording a $50,000 credit sale on 12/31

 ($700,000 + $50,000) / ($100,000 + $50,000)
 $750,000 / $150,000 = 5.00

©McGraw-Hill Education. 5-24

December 31 cash sale (real or fraudulent)

Ratio of Sales to AR shortly before year-end:

$700,000 / $100,000 = 7.00

Recording a $50,000 cash sale on 12/31

 ($700,000 + $50,000) / ($100,000)
 $750,000 / $150,000 = 7.50

©McGraw-Hill Education. 5-25

1. Increasing the numerator of a ratio always
increases the ratio.
2. Increasing the denominator of a ratio always
decreases the ratio.
3. Increasing the numerator and denominator of a
ratio by the same amount:
a. Decreases the ratio if the ratio is greater than 1.
b. Increases the ratio if the ratio is less than 1.

©McGraw-Hill Education. 5-26

 Data analytics is the process of using related and
unrelated data sets to provide insights into
decisions.
 CPA firms are increasing using data analytic
approaches to improve risk assessment, tests of
controls and substantive procedures.
 In risk assessment, sophisticated data analytics can
improve auditors’ assessments of risk by significantly
increasing the sources of data used.
 In tests of controls, data analytics may allow the auditors
to use technology to test 100 percent of the items in a
population by relating data from multiple sources
 Substantive procedures may be improved by using data
from a number of data sources to improve the efficiency
and effectiveness of the procedures.
©McGraw-Hill Education. 5-27
 Review and test management’s process for
developing the estimate.
 Independently develop an estimate to compare to
management’s estimate.
 Review subsequent events or transactions bearing
on the estimate.

©McGraw-Hill Education. 5-28

 Inputs to use in applying valuation techniques (IFRS 13)
 Level 1 – inputs of observable quoted prices in active
markets for identical assets or liabilities
 Ex. A closing stock price in WSJ
 Level 2 – inputs of observable quoted prices, generally
for similar assets or liabilities in active markets
 Ex. Company discounts future cash flows on its not publicly
traded debt securities at rate used by market for publicly traded
debt securities
 Level 3 – inputs that are unobservable for the assets or
liability
 Ex. A private company uses judgment to determine a proper rate to discount the
estimated future cash flows of its not publicly traded securities

©McGraw-Hill Education. 5-29

 Disclosure requirements must be met
 Primary challenge is identifying undisclosed
related party transactions
 Determine related parties
 Inquiries of management
 Review SEC filings, stockholder’s listings and conflict-of-
interest statements
 Be alert for transactions with related parties and any
transactions with unusual terms

©McGraw-Hill Education. 5-30

 Primary functions:
•Support the auditors’ compliance with auditing standards
•Support the auditors’ opinion
 Secondary functions:
•Assists continuing and new audit team members in planning and
performing the audit
•Serves as a record of matters of continuing audit interest
•Assists in supervision and review of the audit
•Demonstrates the accountability of team members
•Assists internal reviewers, external peer reviewers, PCAOB inspectors,
and successor auditors in performing their roles

©McGraw-Hill Education. 5-31

 Audit documentation should be sufficient to:
 Enable an experienced auditor to understand the work
performed and the significant conclusions reached
 Identify who performed and reviewed the work
 Show that the accounting agree or reconcile to the
financial statements
 Audit documentation should include all
significant audit findings and the actions taken to
address them

©McGraw-Hill Education. 5-32

 Audit administrative working papers
 Working trial balance
 Lead schedules
 Adjusting journal entries and reclassification
entries
 Supporting schedules
 Analysis of a ledger account
 Reconciliations
 Computational working papers
 Corroborating documents

©McGraw-Hill Education. 5-33

 Current files
 Current year working papers
 Index and cross-referencing
 Permanent files
 Items of continuing audit interest

©McGraw-Hill Education. 5-34

©McGraw-Hill Education. 5-35
©McGraw-Hill Education. 5-36