Handout #4 Learning objectives addressed by this exercise: Chapter 4-Learning Objective(s) 3 and 5 1. The following are six situations that involve the audit risk model as it is used for planning audit evidence requirements. Numbers are used only to help you understand the relationships among factors in the risk model. Risk Situation 1 2 3 4 5 6 Acceptable audit risk 2% 2% 10% 2% 1% 1% Inherent risk 50% 10% 5% 20% 20% 80% Control Risk 100% 50% 1% 30% 90% 80% Planned detection risk ? ? ? ? ? ? Required: (a) Calculate planned detection risk for each situation (answer using two-decimal form, i.e. 520% = 5.20); 1. 2. 3. 4. 5. 6. (b) Which situation (1-6) requires the greatest amount of evidence and which requires the least?; Most = Least = (c) Using your knowledge of the relationships among the foregoing factors, state the effect on planned detection risk (answer I, D, or N, for increase, decrease, or no effect) and planned evidence of changing each of the following factors while the other two remain constant: I. An decrease in acceptable audit risk II. A decrease in control risk III. An increase in inherent risk IV. A decrease in control risk and a slightly smaller increase in inherent risk of the same amount Learning objectives addressed by this exercise: Chapter 4-Learning Objective(s) 3, 4, and 5 2. Below are ten independent risk factors. Identify which of the following audit risk model components relates most directly to each risk factor. 1. The client lacks sufficient working capital to continue operations. 2. The client fails to detect employee theft of inventory from the warehouse because there are no restrictions on warehouse access and the client does not reconcile inventory on hand to recorded amounts on a timely basis. 3. The company is publicly traded. 4. The auditor has identified numerous material misstatements during the prior year audit engagements. 5. The assigned staff on the audit engagement lack the necessary skills to identify actual errors in an account balance when examining audit evidence accumulated. 6. The client is one of the industrys largest based on its size and market share. 7. The client engages in several material transactions with entities owned by family members of several of the clients senior executives. 8. The allowance for doubtful accounts is based on significant assumptions made by management. 9. The audit plan omits several necessary audit procedures. 10. The client fails to reconcile bank accounts to recorded cash balances. A. Audit Risk B. Inherent Risk C. Control Risk D. Detection Risk Handout #4 Learning objectives addressed by this exercise: Chapter 4-Learning Objective(s) 2, 3, 4, and 5 3. Using the audit risk model, state the effect on control risk, inherent risk, acceptable audit risk, and planned evidence for each of the following independent events. In each of the events a to j, circle one letter for each of the three independent variables and planned evidence: I = increase, D = decrease, N = no effect, and C = cannot determine from information provided. a. The clients management materially increased long-term contractual debt. The company engaged in several new complex derivative transactions during the year: I. Control risk I D N C III. Acceptable audit risk I D N C II. Inherent risk I D N C IV. Planned evidence I D N C b. The company changed from a publicly held company to a privately held company. The company hired a new CFO who performs several key accounting controls and estimates: I. Control risk I D N C III. Acceptable audit risk I D N C II. Inherent risk I D N C IV. Planned evidence I D N C c. The auditor decided to set assessed control risk at the maximum (it was previously assessed below the maximum). This is the second year of the audit and there were no misstatements found in last years audit. For the audit team there is a new partner and manager on the engagement: I. Control risk I D N C III. Acceptable audit risk I D N C II. Inherent risk I D N C IV. Planned evidence I D N C d. An account balance increased materially from the preceding year without apparent reason. The company closed all foreign operations and operates exclusively in the domestic market: I. Control risk I D N C III. Acceptable audit risk I D N C II. Inherent risk I D N C IV. Planned evidence I D N C e. You determined through the planning phase that working capital, debt-to-equity ratio, and other indicators of financial condition all worsened during the past year. The auditor decided to set assessed control risk at the minimum (it was previously assessed below the maximum). This the second year of the audit: I. Control risk I D N C III. Acceptable audit risk I D N C II. Inherent risk I D N C IV. Planned evidence I D N C f. The company is the largest firm in an industry that is characterized by fierce competition. This is the first year of the engagement, and a review of the predecessor auditors working papers shows there were few misstatements found in the previous years audit. The auditor also decided to increase reliance on internal control: I. Control risk I D N C III. Acceptable audit risk I D N C II. Inherent risk I D N C IV. Planned evidence I D N C g. A continuing client has been selling products online to customers through its Web page during the year under audit. Calculations and remittance of tax amounts is complex, but the online customer ordering process is well integrated with the companys accounting system. Client sales staff are experienced and dedicated to accuracy in the performance of their job duties when they are required to print customer order information and enter that data manually into the sales accounting system: I. Control risk I D N C III. Acceptable audit risk I D N C II. Inherent risk I D N C IV. Planned evidence I D N C h. This is the first year of an engagement with a new client. There has been no change in key management personnel. Also, you believe that management sets an appropriate tone with regard to the accuracy financial reporting. The audit firm is being investigated by the PCAOB and the Department of Justice with regard to issues over inappropriate relationships with several other audit clients: I. Control risk I D N C III. Acceptable audit risk I D N C II. Inherent risk I D N C IV. Planned evidence I D N C Handout #4 i. The company recently a defendant in a civil lawsuit, the company was not expected to successfully defend the lawsuit. The company fully expected to suffer a material loss as a result, instead the company has actually been able to recover a substantial portion of attorneys fees devoted to defending the suit. In auditing inventory, you obtain an understanding of internal control and perform tests of controls and find them to be ineffective. You also note that the clients inventory is homogenous and the market value is readily determinable: I. Control risk I D N C III. Acceptable audit risk I D N C II. Inherent risk I D N C IV. Planned evidence I D N C j. In discussion with management, you conclude that management is planning to sell the business in the next few months. Because of the planned changes, several key accounting personnel quit several months ago for alternative employment. The new accounting personnel seem to lack integrity in comparison. You still believe that it is appropriate to do the audit. You also observe that total debt has significantly decreased with that of the preceding year and profitability and liquidity have increased: I. Control risk I D N C III. Acceptable audit risk I D N C II. Inherent risk I D N C IV. Planned evidence I D N C