Using the Audit Risk Model
When you audit a company, your main goal is to provide assurance to the users of the company’s financial statements that those documents are free of material misstatement. You use the audit risk model, which consists of inherent, control, and detection risk, to help you determine your auditing procedures for accounts or transactions shown on your client’s financial statements. These financial statements consist of these three documents:
Income statement: Shows a company’s operating performance (revenues, expenses, and net income)
Balance sheet: Shows a company’s assets, liabilities, and owners’ equity
Statement of cash flows: Shows the company’s sources of cash and cash payments
In addition to these three statements, owner’s equity can be further broken out into a statement of changes in owner’s equity (balance sheet), which details items such as the effect net income and dividends have on owner’s equity. Your client may also have footnotes to the financial statements which reports additional information left out of the main reporting documents, such as the balance sheet and income statement, for the sake of brevity.
Unfortunately, you can’t just trust that a client’s financial statements are complete and accurate. You have to work hard to come to that conclusion — or to determine that certain information is incomplete or inaccurate. And you may encounter situations in which your ability to assess the financial statements is impeded by the client itself. That situation increases your audit risk. Audit risk has two faces:
*You issue an adverse opinion when it’s not warranted. An adverse opinion indicates that the financial statements don’t present the financial data in accordance with generally accepted accounting principles (GAAP). The bottom line is that your client must follow these accounting standards when preparing its financial statements.
How can this type of error happen? Maybe you’re not up to speed with recent changes in GAAP, or you misinterpret a specific accounting principle, leading you to find fault where none exists.
You issue an unqualified opinion when it’s not warranted. An unqualified opinion is the best you can issue. It means the financial statements present fairly, in all material respects, the financial position of the company under audit. Making this mistake means that your client’s financial statements contain material misstatements from either unintentional errors or intentional fraud, and you didn’t catch the problems through your audit procedures.
There are three specific components of audit risk — inherent risk, control risk, and detection risk.
Accounting Glossary
accounting equation
The equation Assets = Liabilities + Equity, which demonstrates the two-sided nature of accounting and is useful for explaining the concept of double-entry accounting (or double-entry bookkeeping).
Accounting Glossary
accounting period
The time period for which financial information is being tracked in a business, such as monthly, quarterly, or annually.
Accounting Glossary
accounts receivable
An account that records the amounts that customers owe to a business.
Accounting Glossary
adjusting entry
A correction made to a bookkeeping account that adjusts for accounting errors or other necessary changes at the end of the accounting period.
Accounting Glossary
cash flows
Used to describe the source or sources of cash or how cash is used.
Accounting Glossary
Chart of Accounts
A list of all the accounts used by a business, including what types of transactions go into each account.
Accounting Glossary
debit
An accounting entry that increases an asset or expense account, and decreases a liability or income account.
Accounting Glossary
dividends
A portion of a company’s profits paid by share of common stock on a quarterly or annual basis.
Accounting Glossary
FASB
Financial Accounting Standards Board. FASB is the highest-ranking authority in the private (non-government) sector of the U.S. for making pronouncements on GAAP and for keeping accounting standards up-to-date.
Accounting Glossary
Federal Unemployment Tax
In the U.S., the fund that used to be known simply as Unemployment. Employers contribute to the fund, and states also collect taxes to fill their unemployment fund reserves. (The acronym FUTA means Federal Unemployment Tax Act.)
Accounting Glossary
fidelity bonds
A type of insurance — typically carried by employers for their employees — that helps guard against theft and reduce the risk of loss.
Accounting Glossary
FIFO
First-in, first-out. A method for costs of goods sold in which a business charges out product costs to cost of goods sold expense in the chronological order in which the goods were acquired.
Accounting Glossary
fungible
Describes a product that is interchangeable and virtually indistinguishable from another product.
Accounting Glossary
General Ledger
A summary of all of a business’s accounts and transactions.
Accounting Glossary
IASB
International Accounting Standards Board. The IASB (based in London) is the main authoritative accounting standards setter outside the U.S.
Accounting Glossary
Journals
The location in which bookkeepers keep records (in chronological order) of daily company transactions.
Accounting Glossary
LIFO
Last-in, first-out. A method for costs of goods sold that selects the last item you purchased first, and then works backward until you have the total cost for the total number of units sold during the period.
Accounting Glossary
LLP
Limited liability partnership. A legal structure that state laws offer to qualified professionals in which all the partners have limited liability.
Accounting Glossary
PC
Professional corporation. A legal structure that state laws offer to qualified professionals who otherwise would have to operate as an unlimited partnership liability.
Accounting Glossary
petty cash
A cash account that businesses keep on hand for unexpected expenses.
Accounting Glossary
revenue
Monies that are collected in the process of selling a company’s goods and services.
Accounting Glossary
salvage value
The amount that an asset is worth after it has been fully depreciated.
Accounting Glossary
statement of cash flows
A financial statement that summarizes a business’s cash inflows and outflows during an accounting period.
Accounting Glossary
transactions
Economic exchanges between a business or other entity and the parties with which the entity interacts and makes deals.
Accounting Glossary
worker’s compensation insurance
A type of insurance carried by employers that covers its employees in case they are injured on the job.
