Q1.

 A. Explain how auditors use the audit risk model when planning an audit.

The audit risk model is a conceptual tool used by auditors to help develop the
audit strategy at the assertion level. Auditors use the audit risk model to help
decide how much and what type of evidence to accumulate for each relevant
assertion.it is DR= AAR/IR*CR where DR stands for detection risk, AAR stands for
acceptable audit risk, IR stands for inherent risk and CR stands for control risk.

The auditors assess risk at the overall financial statement level and at the
assertion level. The auditors will also assess risk level across various assertion
within an individual class of transactions.

 B. Describe the audit risk model and each of its components.

Detection risk: this is the risk that the audit procedure for an audit assertion will
fail to detect misstatements exceeding performance materiality 

Inherent Risk: it measures the auditors’ assessment of the susceptibility of an

assertion to material misstatement, before considering the effectiveness of
related internal controls

Control Risk:  it measures the auditors’ assessment of the risk that a  material
misstatement could occur in an assertion about a class of transaction, an
account balance or disclosure.

Acceptable audit risk: this is a measure of how willing the auditor is to accept
that the financial statements may be materially misstated after the audit is
completed and an unqualified audit opinion has been issued

  

Q2. Below are four situations that involve the audit risk model as it is used for planning
audit evidence requirements in the audit of inventory. For each situation, calculate
planned detection risk.

SITUATION

  1 2 3 4

Acceptable Audit
risk 1% 10% 10% 5%

Inherent risk 100% 100% 50% 20%

Control risk 100% 100% 40% 30%

Detection risk 1% 10% 50% 83.33%

Q3. In practice, auditors rarely assign numerical probabilities to inherent risk, control
risk, or acceptable audit risk. It is more common to assess these risks as high, medium,
or low. For each of the four situations below, fill in the blanks for detection risk and the
amount of evidence you would plan to gather ("planned evidence") using the terms high,
medium, or low.

SITUATION

  1 2 3 4

Acceptable audit
risk Low Low High High

Inherent risk High Low Low Low

 Control risk High Low Medium Low

Detection risk Low Medium Medium High

Planned

evidence High Medium Medium Low

Q4. Lauralye Leasing Limited (LLL) provides lease financing to companies and
individuals for equipment other than automobiles. Leases on commercial signs make up
50% of total leases; computer and telecommunications equipment are 30%; and
restaurant equipment makes up most of the remainder. LLL's customers arrange to buy
new equipment from equipment dealers, then contact LLL to arrange lease financing.

   LLL was founded over thirty years ago by Laura and Al Ye. It is now run by Mr. and
Mrs. Ye's daughter, Betsy, who is the President of LLL. LLL owns a small building
downtown, where the offices of the business are located. Unused office space is rented
out to other commercial tenants.

   Betsy was a classmate of yours at in university and you have kept loosely in touch
over the years. This year, she moved LLL's audit to your firm (a local firm with five
partners), after deciding that the firm her parents had hired many years ago did not
really understand her business needs.

   LLL has a small loan that is used to cover blips in working capital. The company has
two salespeople. Most loans are received from stores throughout the city with whom
LLL has standing agreements. If customers require financing, they fill in an application
and fax it to LLL for approval. LLL will reply within two business days.

   The company has been profitable for many years. There are no extraordinary items
in the current year's financial statements.

Selected financial information is as follows:

 
         Current assets               $9 910 000

         Long term assets         $46 500 000

         Short term liabilities   $30 700 000

         Shareholders' equity   $25 710 000

         Revenue                      $10 200 000

         Expenses                       $5 600 000

         Income before tax         $4 600 000

         (and before bonus)

Required:

A. Which base would you use to calculate materiality? Why?

B. Calculate materiality. Choose a specific number and explain why you chose that
amount.

Answer: 

0. Net income before taxes and bonuses would be used to calculate

materiality because the company has been profitable. We would use Gross
Profit method if a company sells products or has a direct cost relationship
with products, else Total assets, equity and revenue model will likely be
used as base when income fluctuates a lot or a company is experiencing
losses. 

B.  The range applied to net income is 5% to 10%, which would result in a

materiality range of $230,000 to $460,000. The company is a private
company so only the shareholders, banks and creditors are major users.
As only a few users, we would likely go towards the larger end of this range
i.e. $460000.

 
 

  Question 1: For each of the following audit procedures, state and describe the type of audit evidence,
state the audit assertion that it applies to, and describe the reliability of the evidence (with reasons).

A) Watch staff scan products and enter cash received.

B) Reconcile daily cash drawer receipts (cash, debit card sales, credit card sales) with daily sales for one
week.
C) Calculate daily gross profit and gross profit by product line.
D) Account for a sequence of sales documents.
Answer: A) Watch staff scan products and enter cash received.

Type of audit evidence (with Applicable audit Reliability of evidence (high,

reason) assertion medium, or low, with reason)
Medium. Although it is being
performed by the auditor, this is
Observation, as the auditor is a point-in-time test and is
using a sense (vision) to assess limited to the actual duration of
the activity of recording sales Occurrence the observation.

B) Reconcile daily cash drawer receipts (cash, debit card sales, credit card sales) with daily sales for one
week.

Type of audit evidence (with Applicable audit Reliability of evidence (high,

reason) assertion medium, or low, with reason)
Reperformance or
recalculation, as the auditor is
redoing a summary that
would likely be completed by
the information systems of the High, as it is being performed
client Accuracy by the auditor

C) Calculate daily gross profit and gross profit by product line.

Type of audit evidence (with Applicable audit Reliability of evidence (high,

reason)
Analytical procedures, since it
looks at comparisons and
relationships between two or
more figures
assertion medium, or low, with reason)
Low, since it is not considered
sufficient evidence on its own.
It must be combined with tests
of control or tests of detail.
Useful on its own for planning
Accuracy or risk assessment.

D) Account for a sequence of sales documents.

Type of audit evidence (with Applicable audit Reliability of evidence (high,
reason) assertion medium, or low, with reason)
Inspection, as the auditor is
examining client
documentation for the
continuity, or
reperformance, as the auditor High, as it is being performed
is re-doing and checking the by the auditor and is
issuance of an ascending substantiated by client
sequence for sales documents. Completeness documentation.

Question 2: Below are 12 audit procedures. Classify each procedure according to the following types of
audit evidence: 1) inspection, 2) external confirmation, 3) recalculation, 4) observation, 5) inquiry of the
client, 6) reperformance, and 7) analytical procedure.

Type of
Evidence Audit Procedures
1. Watch client employees count inventory to determine whether
. Observation company procedures are being followed.
2. Count inventory items and record the amount in the audit working
Inspection papers.
3. Stand by the payroll time clock to determine whether any
Observation employee "punches in" more than one time.
Analytical 4. Calculate the ratio of cost of goods sold to sales as a test of overall
procedure reasonableness of gross margin relative to the preceding year.
Inquiry of the 5. Obtain information about the client's internal controls by asking
client questions of client personnel.
6. Trace totals from the cash disbursements journal to the general
Reperformance ledger.
7. Examine a piece of equipment to make sure a recent purchase of
Inspection equipment was actually received and is in operation.
Analytical 8. Review the total of repairs and maintenance for each month to
procedure determine whether any month's total was unusually large.
9. The auditor computes the debt covenant based on the financial
information to ensure that the client's calculation was performed
Recalculation correctly.
10. Re-foot entries in the sales journal to determine whether they
Recalculation were correctly totalled by the client.
11. Make a surprise count of petty cash to verify that the amount of
Inspection the petty cash fund is intact.
External 12. Obtain a written statement from the client's bank stating the
Confirmation client's year-end balance on deposit.

Question 3: Following are examples of evidence that could be collected during an audit of financial
statements.
1. Duplicate copies of sales invoices
2. Inspection of new $100 000 cutting machine
3. Bank confirmation
4. Remittance advices
5. Vendors' invoices
6. Standard letter from lawyer to auditor
7. Auditor inventory count sheets
8. Shipping documents
9. Payroll cheques
10. Long-term debt agreements review notes
11. Auditor interest expense calculation worksheet
12. Observation by auditor of computer error message (invalid supplier number)
13. Gross margin calculation
14. Interview notes from interview with credit manager

Required:
Classify each type of evidence as to its reliability (1 - high, 2 - moderate, 3 - low). Justify your
classification.

Type of Audit Evidence High/Low/ Justification

medium
Duplicate copies of sales invoices Moderate Moderate - Internal Documentation if internal
control (I/C) is good; otherwise, low if I/C is
poor
Inspection of new $100 000 cutting High High - physical inspection - auditor's direct
machine knowledge
Bank confirmation High High - external confirmation - independence of
provider
Remittance advices High High - external documentation - document has
been circulated to a party outside the entity
Vendors' invoices High High - external documentation - evidence
comes from an external party
Standard letter from lawyer to High High - external confirmation - independence of
auditor provider
Auditor inventory count sheets High High - physical inspection - auditor's direct
knowledge
Shipping documents Moderate Moderate - internal documentation if internal
control is good; otherwise, low if I/C is poor
Payroll cheques High High - external documentation - evidence
comes from an external party

Long-term debt agreements review High High - external documentation - evidence

notes comes from an external party
Auditor interest expense calculation Moderate Moderate - analytical review - reasonableness
worksheet test (also valid: High - reperformance)
Observation by auditor of computer Moderate Moderate - observation - client is aware that
error message (invalid supplier the auditor will be observing (depends on
number) quality of internal controls)
Gross margin calculation Moderate Moderate - analytical review - reasonableness
test (also valid: High - reperformance)

Interview notes from interview with Low Low - enquiry of client - evidence is not from an
credit manager independent source

Question 4: A) There are four important purposes of analytical procedures. Identify each of these four
purposes and for each purpose give a specific example of an analytical procedure that an auditor might
perform.
B) Identify each of the five major types of analytical procedures and give an example of each.
C) One purpose of performing analytical procedures in the planning phase of an audit is to assess the
client's financial condition. Explain how the assessment of a client's financial condition can affect the
auditor's decisions concerning evidence accumulation in later phases of the audit.

Answer:
A) Four important purposes of analytical procedures are:
• to help the auditor understand the client's industry and businessthe auditor might analyze recent
trends in the client's gross margin percentages to assess the effects of competition in the industry
• to aid in the assessment of the client's ability to continue as a going concernthe auditor might
analyze several of the client's key ratios including the ratio of long-term debt to net worth, the ratio of
profits to total assets, and the current ratio
• to indicate the presence of possible misstatements in the financial statementsthe auditor might
compare the current year's unaudited account balances with the previous year's audited balances
• to reduce the extent of detailed teststhe auditor might perform a simple analytical procedure such
as multiplying the client's monthly rent times 12 as a test of the client's rent expense account; if the
product agrees with the balance in rent expense, no additional testing of the account may be necessary

B) The five major types of analytical procedures are:

• Compare client and industry data. Compare the client's gross margin percentage with the industry's
average gross margin percentage to compare the client's performance with that of the average company
in the industry.
• Compare client data with similar prior-period data. Compare the client's gross margin percentage
for the current year with that of the previous two years to compare the client's performance in the
current year with that of previous years.
• Compare client data with client-determined expected results. Compare client's current-year raw
material expense with budgeted expense.
• Compare client data with auditor-determined expected results. Calculate an expected value for the
allowance for bad debts account by multiplying the three-year moving average of the client's allowance
as a percentage of gross accounts receivable by the current year's ending balance in gross accounts
receivable, then compare this expected value with the client's actual value.
• Compare client data with expected results using nonfinancial data. Calculate an expected value for
the client's payroll by multiplying total hours worked by the wage rate, then compare the resulting
product with the client's recorded payroll expense.

C) The weaker the client's financial condition, the more assurance the auditor will require that the
financial statements are free of material misstatements. As the auditor requires greater assurance, he or
she can
1) perform detailed testing closer to the balance sheet date,
2) increase the extent of detailed testing, or
3) perform more reliable procedures.

If the auditor believes the entity is not a going concern, he or she will require proper financial statement
disclosure and presentation in order to issue an unqualified audit opinion.

 Q5. CASE 6-41.

You can use the following template to answer this question:

(Note: Sales have increased 12 percent over the prior year. Four percent of that is due
to an increase in the average selling price. The remaining 8 percent is attributed to an
increase in the number of units sold.) 

increase in the number of units sold.) 

Expected Difference
Value in Reasoning
(rounded to expected to support
nearest Recorded and expected Assessment
Account dollar) Amount recorded Value of Analysis
Sales n/a $57,474,182.00 n/a n/a
Executive $563,348 $615,970.00 -8.54% 3% Salary
 Increase from
prior year
Salaries audit
Laid-off
Factory employees
Hourly Pay $10,340,043 $11,476,319.00 -9.90% Recalled
3% Salary
Factory Increase from
Supervisors' prior year
Salaries $809,400 $810,588.00 -0.15% audit
3% Salary
Increase from
Office prior year
Salaries $2,050,005 $2,055,302.00 -0.26% audit
5% Sales
commission More detail
calculated needed to be
based on looked at into
total sales the breakdown
Sales (the reported and calculation
Commissions $2,873,709 $2,367,962.00 21.36% amount used) of commission

Q1. Table 1: Complete the following table

Transaction-related Audit Possible Internal Controls Common Tests of Controls

Objective
1. Recorded acquisitions are
for goods and services
received, consistent with the
best interests of the client
(occurrence).
2. Existing acquisition
transactions are recorded
(completeness).
3. Recorded acquisition
transactions are correctly
recorded (accuracy).
4. Cash disbursements are
recorded on a timely basis in
the correct accounting period
(cutoff).
5. Acquisition transactions are
recorded in the correct
Receiving reports, purchase
orders and alternative
supporting documents are
attached to the voucher and
approved and verified internally.
Vouchers are pre-numbered and
accounted for and purchase
orders.
Calculations and amounts
are internally verified.
Vouchers are pre-numbered and
accounted for and cash receipts.
Chart of accounts is used to
Reviewing the acquisition
general ledger and
vouching of supporting
documentation.
Tracking down
receiving reports to
acquisition ledger
Recomputing and
comparing recorded
transactions in the
acquisition journal with
supporting
documentation
Perform on a sample
of transactions to
obtain sufficient
evidence
Check for correctness
of classification with
 account (classification). record acquisition and chart of accounts
classifications are internally
verified

Q2. Chapter 13-29

W = Weakness I = Implication of Weakness to the R = Recommendation to

Organization (Describe the Improve the Control
Potential Fraud and/or Error) Weakness

1 This can lead and has led to the Having a system where the
property tax being paid twice original bill and the reminder
Authorizing the original notice are stapled together or
and the reminder notice for organized together will keep
the property tax this mix up from happening

2 This can lead to a double payment By routinely going over the

of an invoice or remittance chart of accounts to see if
Having multiple accounts there aren’t any duplicates
in the system for the and when adding an account
same organization double checking there isn’t
already and existing one
3 This can cause large amounts to By double checking or having
be transferred to the wrong someone else double check
Completing large transfers account and make out a line of the transfer this can be solved
without double checking credit

4 This can lead to payments which Segregation of duties is

Multiple roles, reconcile
and maintain accounts.
Also pre authorise
payments and collect
money from wholesalers
can be unauthorised by other
departments and also cannot be
found until someone else
reconciles.
essential as then double
entries are detected early and
hence double payments and
also misappropriation can be
handled properly.

Q3. Table 4: Complete the following table

Liability that Could Be Uncovered Describe Audit Procedure to Uncover Liability

a. Lawsuit Contingent liability related to the minutes of the

board of directors meetings
b. Building used as collateral for a loan Inspect ownership records and bank certification

c. Unrecorded lease Examine the lease agreement or rent expense

d. Note payable Analyze the relevant loan's fundamental

documents

e. Policy loan Verification from a life insurance provider

f. Note payable Acquire bank approval

g. Income taxes payable for Evaluate the travel and expenditure report
nondeductible expenses
Table 5: Complete the following table

ACCOUNT POTENTIAL AUDIT PROCEDURES

● Completeness (Existing acquisitions are recorded)

1. Cost of goods sold.
● Accuracy (Acquisitions are recorded accurately)

Inspection of the physical process can provide evidence to

the auditor of confidence.

2. Travel an FDA d entertainment ● Accuracy (recorded cash disbursements are

accurate)

● Completeness (All cash disbursements are recorded)

The auditor can observe the reconciliation process to
determine if there is a likelihood of these procedures being
correctly followed

3. Telephone ● Completeness ( are all transactions recorded)

● Cutoff (is this being recorded in the correct period)

The auditor can review whether all the telephone bills are
on company name and also verify that all monthly bills are
reflected in the current year.

4. Legal expense ● Completeness ( are all transactions recorded)

● Classification (are payments classified correctly)

To test this, the auditor can examine the account

classification and procedures manual, as well as examine
payment cheques sequence.

5. Depreciation expense ● Cutoff (is this being recorded in the correct period)

● Accuracy (is the amount being recorded correctly)

 The auditor can review previous depreciation payment
schedules, as well as re-calculate the amounts to
determine the confidence that the transactions lack
errors.

6. Bad debt expense ● Existence

● Accuracy

● Cutoff

The auditor can cross-check the receivables to sales

orders following company procedures to determine if the
stated amounts are in fact correct and reflect the current
period to a high degree of confidence that the
transactions were recorded correctly.

7. Other expense ● Classification

● Accuracy

● Occurrence
Auditor would verify that all the expenses have occurred to
the client and are relevant to that business and in the
accounting period. Expenses should also have been
classified properly according to category. And also vouch for
accuracy of numbers.

8. Gain on the sale of assets ● Cutoff

● Classification

● Accuracy

The auditor would need to verify the acquisition and

disposal periods for assets reported gains on sale.
Additionally, the recalculation of depreciation applied
(where necessary) would provide a higher degree of
confidence in the accurate reporting of the sale.