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Chapter 2

MGMT 138 Chapter Notes - Chapter 2: Financial Statement, Audit Evidence, Audit Risk

Course Code
MGMT 138
Patricia Wellmeyer

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Chapter 2:
Reasonable assurance: high level of assurance but not absolute
Material misstatement: error or fraud in the financial statements that might cause a user of them to change his or
her decision about the company
Sufficient appropriate audit evidence: quantity and quality of the evidence gathered
Audit risk: risk that the auditor will fail to issue an opinion saying that the financial statements are materially
misstated when they actually are
Before accepting an audit engagement for a new client, the auditor should request information from the
previous auditor
The Planning Phase of the audit process:
1. Consider the preconditions for an audit and accept or reject the audit engagement
2. Understand the entity and its environment, determine materiality, and asses the risks of material
a. Entity and environment
a.i. Identify and assess the risk of material misstatement
a.ii. Learn about the business and become familiar with the industry
a.iii. Required to understand internal controls relevant to the audit (understand the internal
controls for the relevant assertions related to the significant or material accounts)
a.iii.a) Relevant assertions: those that management makes about the company’s
financial statements that have a reasonable possibility of containing a material
b. Materiality
b.i. Based on auditor’s professional judgment
b.ii. Material misstatement: error or fraud in the financial statements that could cause the
users of the financial statements to change their decision about the company
b.iii. Misstatements are considered to be material, individually or in the aggregate, if they
would cause decisions to be changed
b.iv. Auditor makes decisions about the size of misstatements that will be considered material,
which allow the auditor to determine the nature, timing, and extent of risk assessment
b.v. Base amount (greater of total assets or total revenue)
b.vi. Planning Materiality + (Excess x Factor) = Preliminary Materiality Level
b.vii. Determining materiality for particular items on the financial statements
b.viii. Tolerable misstatement (performance materiality): a portion of the materiality assigned to
individual accounts
c. Assess the risk of material misstatement
c.i. Work papers (working papers): written record of the evidence gathered by the auditor,
must include a discussion of the risk of fraud
c.ii. Material: knowing about a misstatement that is material would cause an outsider to
change his decision regarding the company
c.iii. Misstatement: error (unintentional) or fraud (intentional) in the financial statements
c.iv. To identify the risk of a material misstatement, the auditor considers material
misstatements at both the financial statement level and the relevant assertion level
c.iv.a) Financial statement level: has potential to affect many assertions or many
c.iv.b) Relevant assertion level: involves a declaration (existence or
completeness) for a class of transactions or account balances
3. Develop an audit strategy and an audit plan to respond to the assessed risks
a. Key decisions about its scope, timing, and conduct
Audit risk: the possibility that the auditor will express an inappropriate audit opinion when the financial
statements are materially misstated
oRisk that the auditor will issue an unqualified opinion when the financial statements are materially
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