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Chapter 3. Management Fraud and Audit Risk. stages of an audit. Obtain (or retain) engagementCH 2 Engagement planning SoFW #1CH 3-4 Risk assessment (int cont) SoFW #2CH 5 Substantive Procedures SoFW #3 reporting R S CH 12. Alyssia.

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Chapter 3

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Chapter 3

Chapter 3

Management Fraud

and

Audit Risk


Stages of an audit

stages of an audit

Obtain (or retain) engagementCH 2

Engagement planning SoFW #1CH 3-4

Risk assessment (int cont) SoFW #2CH 5

Substantive Procedures SoFW #3

reporting R S CH 12


Alyssia

Alyssia

What is the definition of Audit Risk


Chapter 3

Nick

What is the definition of Control Risk


Jason g

Jason G

What is the definition of Detection Risk


Chris mc

Chris Mc

What are the elements of the “Audit Risk Model”?

What is the Audit Risk Model ?


Engagement planning

Engagement planning

the Audit Risk Model

AR = IR * CR * DR

page 82

in our class

let IR = 1.00 AR = CR * DR


Engagement planning1

Engagement planning

the Audit Risk Model

let IR = HIGH AR = CR * DR

Matrix on Page 84

We are only going to look at the diagonal


Engagement planning2

Engagement planning

the Audit Risk Model

Risk of Material Misstatement

RMM = combines IR and CR


Tracy

Tracy

Describe the relationship between Control Risk and the required level of Detection Risk?

The mathematical relationship


Audit risk model

Audit Risk Model


Audit risk model1

Audit Risk Model


Audit risk model2

Audit Risk Model


Audit risk model3

Audit Risk Model


Preliminary audit strategies

preliminary audit strategies


Darryn

Darryn

What are the two basic audit approaches?


Engagement planning3

Engagement planning

the Audit Risk Model

Diagonal of Matrix on Page 84

let IR = HIGH or 1.00 AR = IR* CR * DR

We will focus on these as approaches


Engagement planning4

Engagement planning

AR = IR* CR * DR

Reduced level of Control Risk

Primarily Substantive


Jason c

Jason C

Which Component(s) of Audit Risk is the auditor unable to reduce?

Which Component(s) of Audit Risk can the auditor reduce?


Craig

Craig

Describe a Significant Class of Transactions ?

Describe a Transaction Cycle?

page 95


Chapter 3

Class of Transactions

Accounts receivablexxx.xx

Salesxxx.xx

Revenue & Collection Cycle

Accounts receivablexxx.xx

Salesxxx.xx

Cashxxx.xx

Accounts receivablexxx.xx


David

David

Under which Audit Approach are we required to Understand the Internal Controls?


Rachel

Rachel

Why are we required to obtain an understanding of the internal controls when we are taking

the primarily substantive approach ?


Planning phase

planning phase

we are required to obtain an understanding of the Internal Control Structure under both Audit Approaches

The auditor must obtain a sufficient understanding of the entity, its environment, including its internal control, to assess the risk of materialmisstatement and to design the nature, timing, and extent of the audit procedures


Jesun

Jesun

Under which Audit Approach are we required to evaluate the design of the internal controls and assess the risk of material misstatement?

remember RMM = IR*CR


Stages of an audit1

stages of an audit

Obtain (or retain) engagementCH 2

Engagement planning SoFW #1CH 3-4

Risk assessment (int cont) SoFW #2CH 5

Substantive Procdures SoFW #3

reporting R S CH 12


Patrick

Patrick

Under which Audit Approach are we required to TEST the effectiveness of the Internal Controls?


Rob f

Rob F

Under which audit approach are we required to obtain sufficient appropriate evidence?


Chapter 3

we are required to obtain sufficient appropriate evidence under both audit approaches

The auditor must obtain sufficient appropriate audit evidence through audit procedures to afford a reasonable basis for an opinion


Kathleen

Kathleen

If CR = Low, what does that tell us about the allowable level of DR …. ?

If CR = High, what does that tell us about the required level of DR …. ?


Randy

Randy

If we assess CR = Low, will we need to TEST the effectiveness of the Internal Controls?


Sunny

Sunny

If we want to assess Control Risk as Low, what will the evidence provided by our audit procedures need to demonstrate?


Chapter 3

Lisa

If we assess CR = Max, will we need to TEST the effectiveness of the Internal Controls?


Chapter 3

Tony

If the allowable level of DR = High, what does that tell us about Control Risk …. ?

If the required level of DR = Low, what does that tell us about Control Risk …. ?


Chapter 3

Song

If the required level of DR = Low, will we need to perform extensive Substantive Tests?


Chapter 3

Kyle

If we plan the audit to result in Low Detection Risk, what will the evidence provided by our audit procedures need to demonstrate?


Sarah

Sarah

If the required level of DR = MAX, will we need to perform extensive Substantive Tests?


Cesar

Cesar

In your statistics class, why does a larger sample increase your level of confidence?

How does evidence reduce risk?


Chapter 3

Ben

What is the definition of Materiality


Keith

Keith

Given the definition of Audit Risk

what is the relationship between

materiality and Audit Risk?


Chapter 3

what is the risk the courts will decide that the financial statements are materially misstated if the courts decide that

$5,000,000 is material

500 is material


Lindsey

Lindsey

Name 5 different of audit procedures


Audit procedures

Audit procedures

  • Inspection of records and documents

  • Vouching or Tracing

  • Inspection of Assets

  • Observation

  • Inquiry

  • Confirmationthe sample size project

  • Recalculation

  • Re performance

  • Analytical procedures


High risk areas and transactions

High Risk Areas and Transactions


Chapter 3

  • 1. Accounting Estimates

  • 2. Non Routine Transactions

  • 3. Complex Transactions

  • 4. Related Party Transactions


1 accounting estimates

1. Accounting estimates


Auditing accounting estimates

Auditing accounting estimates

high risk

Considerations for control over

audit estimates bottom of p. 389

Keep track of differences


Auditing accounting estimates1

Auditing accounting estimates

With estimates, there often is no right answer

  • Keep track of differences between the estimate and what auditor finds reasonable

  • Evaluate differences taken together


2 non routine transactions

2. Non Routine Transactions

high risk


3 complex transactions

3. Complex Transactions

high risk

page 383


4 related party transactions

4. Related Party Transactions

high risk


Related party transactions

Related Party Transactions

high risk - page 382

One of the parties is in a position to exert significant influence over another party

Related parties can structure transactions to conceal problems in the financial statements


Related party transactions1

Related Party Transactions

page 119

blue box on page 121


Chapter 3

Kim

Please describe Professional Skepticism ?


Chapter 3

Professional Skepticism

.07Due professional care requires the auditor to exercise professional skepticism. Professional skepticism is an attitude that includes a questioning mind and a critical assessment of audit evidence. .....

.09The auditor neither assumes that management is dishonest nor assumes unquestioned honesty. In exercising professional skepticism, the auditor should not be satisfied with less than persuasive evidence because of a belief that management is honest.

See page 69 (bottom)


Red flags

“red flags”


Fraud risk factors page 73

“Fraud Risk Factors” page 73

  • Domination by one individual or a small group of individuals

  • Aggressive attitude toward financial reporting

  • Excessive emphasis on earnings

  • Turnover of employees

  • Evasive responses to auditors’ questions


Fraud risk factors page 731

“Fraud Risk Factors” page 73

  • The audit client’s profits lag the industry

  • The audit client is in a declining industry


Fraud risk factors page 732

“Fraud Risk Factors” page 73

  • audit client has a Weak internal control environment

  • client unable to generate sufficient cash flow

  • Highly profitable, complex hard-to-audit transactions

  • Related party transactions

  • Highly profitable transactions near year-end


Illegal acts red flags page 77

Illegal Acts – Red Flags page 77

  • Government investigations

  • Regulatory reports of violations

  • Unusually large cash payments

  • Unexplained payments to Gov’t officials

  • Failure to file tax returns


Page 69 the blue box

page 69 – the Blue Box

  • Fraud

  • Embezzlement

  • Larceny

  • Defalcation

  • Direct effect illegal acts


Aaaaaaron

Aaaaaaron

From the auditors’ perspective, what is fraud ?


Chapter 3

AU Section 316

Consideration of Fraud in a Financial Statement Audit

(Supersedes SAS No. 82)

Source: SAS No. 99.

Effective for audits of financial statements for periods beginning on or after December 15, 2002.


Chapter 3

Description and Characteristics of Fraud

.05Fraud is a broad legal concept ....................... For purposes of the section, fraud is an intentional act that results in a material misstatement in financial statements

.06Two types of misstatements are relevant to the auditor's consideration of fraud—misstatements arising from fraudulent financial reportingand misstatements arising from misappropriation of assets.

•Misstatements arising from fraudulent financial reporting are intentional misstatements or omissions of amounts or disclosures in financial statements designed to deceive financial statement users ...........

•Misstatements arising from misappropriation of assets (sometimes referred to as theft or defalcation) involve the theft of an entity's assets ..........

.07Three conditions generally are present when fraud occurs. First, management or other employees have an incentiveor are under pressure, which provides a reason to commit fraud. Second, circumstances exist— …. ineffective controls, -that provide an opportunity for a fraud to be perpetrated. Third, those involved are able to rationalize committing a fraudulent act.


National commission on fraudulent financial reporting

National Commission onFraudulent Financial Reporting

Fraudulent financial reporting is intentional or reckless conduct, whether by act or omission, that results in materially misstated financial statements


Illegal acts

Illegal Acts

Indirect-effect illegal acts

Direct effect illegal acts


Christine

Christine

  • To whom does the auditor report Illegal Acts of which they become aware


After discovering an illegal act

After discovering an Illegal Act

  • Inconsequential – minor misappropriation by low level employees

    • Report to management one level above

  • Frauds that could cause material misstatement

  • Illegal acts involving senior management

    • Report to the Board of Directors


Chapter 3

Max

Private Securities Litigation Reform Act 1995

  • When auditors believe an illegal act has a material effect on the financial statements

  • Describe the reporting process for the Board of Directors and the Auditor


After discovering an illegal act1

After discovering an Illegal Act

  • Private Securities Litigation Reform Act 1995

  • When auditors believe an illegal act has a material effect on the financial statements

    • Notify the Board of Directors

    • The Board must notify the SEC within 1 day

    • If the Board doesn’t notify SEC

    • Auditor must notify the SEC


  • Audit program

    Audit Program

    • Examples page 253 6B-2

    • Examples page 296 7B-1 & 7B-2


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