CHAPTER

AUDIT PLANNING
2
2-1. Audit risk: The risk that the auditor may unknowingly fail to appropriately modify
his/her opinion of financial statements that are materially misstated.
Inherent risk: Relates to the susceptibility of an account balance or class of
transactions to error that could be material. . .assuming that there were no related
internal controls.
Control risk: The risk that material errors or irregularities are not prevented or
detected by the system of internal control.
Detection risk: The risk that errors or irregularities which are not prevented or
detected by the system of internal control, are not detected by the independent
auditor.

2-2. Study of the business and industry, and application of analytical procedures during the
planning stage of the audit assist in evaluating inherent risk. These procedures
may permit the auditor to assess inherent risk below the initial 100% assumed
level.

2-3. Sources of business and industry information are the following:

a. Management inquiry
b. Permanent audit workpaper file
c. Internal client documents (e.g. correspondence files, minutes, accounting
manuals, and policy and procedures manuals)
d. PICPA audit and accounting guides
e. Industry trade publications
f. Government publications
g. Credit reports (Dunn & Bradstreet, banks, etc.)
h. Computer data bases
i. Business periodicals

2-4. a. The audit risk model is

Audit risk (AR) = Inherent risk (IR) x Control risk (CR) x Detection risk (DR)

b. The audit risk model is useful in managing audit risk for assertions. By
determining planned audit risk for an assertion, assessing inherent and control
2-2 Solutions Manual to Accompany Applied Auditing, 2006 Edition

risks, an auditor can determine the allowable detection risk (the amount of
detection risk an auditor can allow) for an assertion. Allowable detection risk
is used to determine the nature, timing, and extent of audit procedures for the
assertion.

2-5. The amount of audit evidence an auditor must gather varies inversely with allowable
detection risk. As allowable detection risk decreases, the amount of evidence
required increases, and vice versa. Chapter 2 introduces audit procedures and
discusses how auditors modify audit procedures to obtain sufficient competent
evidential matter by changing (1) the nature, (2) the timing, or (3) the extent of
procedures.

2-6. a. Analytical procedures are used for these broad purposes:

To assist the auditor in planning the nature, timing, and extent of other
auditing procedures.
As a substantive test to obtain evidential matter about particular
assertions related to account balances or classes of transactions.
As an overall review of the financial information in the final review stage
of the audit.

b. An auditors’ expectations are developed from the following sources of

information:
Financial information for comparable prior periods giving consideration
to know changes.
Anticipated results--for example, budgets, forecasts, and extrapolations.
Relationships among elements of financial information within the period.
Information regarding the industry in which the client operates.
Relationships of financial information with relevant nonfinancial
information.

c. The factors that influence an auditor’s consideration of the reliability of data

for purposes of achieving audit objectives are whether the
Data were obtained from independent sources outside the entity or from
sources within the entity.
Sources within the entity were independent of those who are responsible
for the amount being audited.
Data were developed under a reliable system with adequate controls.
Data were subjected to audit testing in the current or prior year.
Expectations were developed using data from a variety of sources.

2-7. a. (4) b. (4)

2-8. a. (1) b. (1) c. (1)

2-9. a. (1) b. (2) c. (3)

 Audit Planning 2-3

2-10. a. The audit risk model gives the following results:

AR = IR x CR x DR (or) DR x AR / (IR x CR)

(1) 2.5% (4) 3.33%

(2) 0.67% (5) 2.5%
(3) 1

In the third situation, the auditor does not have to accumulate any evidence
because inherent risk and control risk give the appropriate level of planned
audit risk.

b. (1) 3 (tied) (4) 2

(2) 5 (5) 3 (tied)
(3) 1

2-11. a. 1. Audit risk is the risk that the auditor may unknowingly fail to
appropriately modify an opinion on financial statements that are
materially misstated.

2. Inherent risk is the susceptibility of an account balance or class of

transactions to error that could be material, when aggregated with error in
other balances or classes, assuming that there were no related internal
controls.

Control risk is the risk that error in an account balance or class of

transactions that could be material, when aggregated with error in other
balances or classes, will not be prevented or detected on a timely basis by
controls.

Detection risk is the risk that an auditor’s procedures will lead the auditor
to conclude that error in an account balance or class of transactions that
could be material, when aggregated with error in other balances or
classes, does not exist, when in fact such error does exist.

3. Inherent risk and control risk differ from detection risk in that they exist
independently of the audit of financial statements, whereas detection risk
relates to the auditor’s procedures and can be changed at the auditor’s
discretion. Detection risk should bear an inverse relationship to inherent
and control risk. The less inherent and control risk the auditor believes
exists, the greater the acceptable detection risk.

b. 1. Materiality is the magnitude of an omission or misstatement of

accounting information that, in the light of surrounding circumstances,
makes it probable that the judgment of a reasonable person relying on the
information would have been changed or influenced by the omission or
2-4 Solutions Manual to Accompany Applied Auditing, 2006 Edition

misstatement. This concept recognizes that some matters, either

individually or in the aggregate, are important for the fair presentation of
financial statements in conformity with generally accepted accounting
principles whereas other matters are not important.

2. Materiality is affected by the nature and amount of an item in relation to

the nature and amount of items in the financial statements under
examination, and by the auditor’s judgment as influenced by the
auditor’s perception of the needs of a reasonable person who will rely on
the financial statements.

2-12. The primary issue raised here is how friendly an auditor should be with client
personnel. This situation is especially interesting in light of the auditor’s view of
the relationship prior to being assigned significant responsibility. The issue is
whether Josie is trying to become friendly in order to try to manipulate the
auditor’s decisions.