Advanced Topics in Assurance Explained
1. Audit Risk Model
The Audit Risk Model is a framework used by auditors to assess the risk that a material misstatement in the financial statements may occur and not be detected by the auditor. It consists of three components: Inherent Risk, Control Risk, and Detection Risk.
Example: An auditor assesses a company's inventory system and determines that the inherent risk of inventory misstatement is high due to complex valuation methods. The auditor then evaluates the company's internal controls and finds that control risk is moderate. To manage overall audit risk, the auditor increases the extent of substantive procedures, thereby reducing detection risk.
2. Materiality
Materiality is the concept that determines the significance of an item in the financial statements. Auditors use materiality to focus their efforts on areas that could significantly impact the users' decisions.
Example: A company's financial statements show revenue of $100 million. An error of $50,000 in the revenue figure is considered immaterial because it represents only 0.05% of total revenue. However, an error of $5 million would be material as it represents 5% of total revenue and could influence users' decisions.
3. Going Concern
The Going Concern concept assumes that an entity will continue to operate for the foreseeable future. Auditors must evaluate whether there are conditions or events that cast significant doubt on the entity's ability to continue as a going concern.
Example: A manufacturing company has significant losses and is unable to pay its debts as they become due. The auditor assesses these conditions and concludes that there is substantial doubt about the company's ability to continue as a going concern. The auditor's report includes an emphasis of matter paragraph to highlight this concern.
4. Audit Evidence
Audit Evidence is information used by the auditor to draw conclusions on the financial statements. It includes both internal and external sources of information, such as documents, confirmations, and analytical procedures.
Example: An auditor obtains bank confirmations from a company's bank to verify the accuracy of cash balances reported in the financial statements. The auditor also performs analytical procedures by comparing current year revenue with prior years to identify any unusual trends.
5. Audit Procedures
Audit Procedures are specific actions taken by the auditor to gather evidence. These procedures include inspection, observation, inquiry, and recalculation, among others.
Example: To verify the accuracy of accounts receivable, an auditor may perform the following procedures: inspect sales invoices, observe the physical counting of inventory, inquire with the sales department about credit terms, and recalculate the allowance for doubtful accounts.
6. Audit Sampling
Audit Sampling involves selecting a subset of items from a population to test. The auditor uses the results from the sample to draw conclusions about the entire population.
Example: An auditor needs to test accounts payable for a company with thousands of vendors. Instead of testing every vendor, the auditor selects a random sample of 100 vendors and performs tests on their invoices and payments. The results from this sample are used to infer the accuracy of the entire accounts payable population.
7. Internal Control Evaluation
Internal Control Evaluation is the process by which auditors assess the effectiveness of an entity's internal controls to determine the nature, timing, and extent of their audit procedures.
Example: An auditor evaluates the internal controls over cash receipts by observing the segregation of duties, testing the reconciliation of bank statements, and reviewing the approval process for cash disbursements. Based on this evaluation, the auditor determines the level of reliance on these controls and adjusts the audit procedures accordingly.
8. Fraud Risk Assessment
Fraud Risk Assessment involves identifying and evaluating the risks of material misstatement due to fraud. Auditors must consider both fraudulent financial reporting and misappropriation of assets.
Example: An auditor assesses the risk of fraudulent financial reporting by evaluating management's incentives and pressures, such as meeting earnings targets. The auditor also assesses the risk of misappropriation of assets by reviewing the controls over cash handling and inventory management.
9. Audit Documentation
Audit Documentation, also known as working papers, is the record of the auditor's work. It includes the procedures performed, evidence obtained, and conclusions reached during the audit.
Example: An auditor documents the steps taken to verify the accuracy of inventory, including the physical count, inspection of inventory tags, and review of inventory turnover ratios. This documentation serves as evidence of the audit procedures performed and supports the auditor's conclusions.
10. Audit Reporting
Audit Reporting involves the communication of the auditor's findings in the form of an audit report. The report includes the auditor's opinion on the financial statements, any qualifications, and any emphasis of matter paragraphs.
Example: An auditor issues an unqualified audit report with an emphasis of matter paragraph regarding the company's ability to continue as a going concern. The report states that the auditor's opinion is not modified, but the emphasis of matter paragraph highlights significant uncertainties that users should consider.