 Hello and welcome to the session. This is Professor Farhad and the session we would look at an actual CPA simulation that was released by the AI CPA. The simulation is covered on the auditing and attestation exam. As always I would like to remind you to connect with me with on LinkedIn if you haven't done so. YouTube is where you would need to subscribe. I have 1600 plus accounting, auditing, finance and tax lectures. These are the courses that I cover including hundreds of CPA questions. On my website I offer additional resources such as multiple choice, true false, CPA simulations, exercises or quasi CPA simulation exercises, 2000 plus CPA questions as well as additional resources covering a lot of topics. In this simulation specifically we're going to be looking at the audit risk model but if you want to learn more about the audit risk model please go to my YouTube or type Farhad audit risk model to find the audit risk model that we're going to be covering in the CPA simulation. Let's take a look at the simulation and luckily not luckily the simulation does not have any exhibits so it's pretty straightforward in a sense that the information is limited to what you are giving here. Basically it's an exercise. When we talk about the simulation the simulation sometimes is no more than just an exercise from your college textbook. That's all what's to it. That's all what's to assimilation is. Best wood furniture and non-issure that produces wood furniture is undergoing gear to audit. The situation below described changes made during year two that may or may not contribute to the audit risk. That's why I told you it's going to be about the audit risk model. So if you don't understand the audit risk model I strongly suggest you view my audit risk model. Type Farhad audit risk model or go to my auditing course and you will find the audit risk model. For each situation select the impact if any that the situation has on the specific component of the audit risk model for year two audit. Selection may be used once more than once or not at all consider each situation independently. Now once there is tax just look at the tax. So basically they want you to know with that decrease internal control, decrease deduction risk, decrease inherent risk, increase control risk, increase deduction risk, increase inherent risk. What are we talking about here? We're talking about control risk, inherent risk and deduction risk. Those three together, those three together they represent audit risk. They represent audit risk. Now you need to understand what is control risk, what is inherent risk and what's deduction risk. Now if you don't understand those then you're going to be in trouble for the auditing exam like in big trouble because I can assure you the audit risk model, the audit risk model is covered. So for example do you know what a control risk? The control risk is the risk that your internal control does not detect, does not detect financial and statement. If we say that your control risk is high it means it's not good. It means your internal control you don't have good internal control if we say control risk is high. So if we say control risk is low it means your control risk is good. We can rely on it more than if it was high. Now inherent risk, you need to know what inherent risk is. I'm going over these very briefly. You want to go to my lecture before we answer the questions in order to really understand them. If you understand them you'll try to solve the simulation. So inherent risk is when the auditor in advance try to make a prediction where the misstatement is most likely or least likely to appear. What do I mean by this or to occur? For example, certain transactions are more likely to have mistakes. Like what? When you make an estimate, when you make an estimate you are simply making an estimate. You're making a guess. When you make a guess there's a good chance you might make a mistake even in good faith let alone make an mistake on purpose which is either make an error, an error or worst committing fraud. So the inherent risk is for example if you have complex transaction there's inherent risk. Certain accounts are more inherent than other, maybe cash because it's subject to theft. For example, if you have derivatives, complex financial instruments, guess what? These accounts are inherently risky because they're complex. So when we say inherent risk is high it means there's more risk. If we say this account inherent risk is low then there's less risk. And detection risk, what is detection risk is the risk of not detecting an error. What does that mean? It means you do your job but there's still risk of not detecting an error. So if you want to reduce that detection risk what do you do? You do more work. So if you want to say I want to reduce my detection risk as low as possible well guess what? If you want to reduce your detection risk the risk of making an error do more work. It's as simple as that. So these risks are but when you get to the exam you have to know what they are and you have to apply them immediately in a problem like if you are prepared this should be walk in the park in my opinion if you know the audit risk model but let's go over it to see how it works. In year two the auditor noted that the company's newly hired purchasing agent was not obtaining competitive bids on all major purchase requisition as required. Here we go. This is the situation. This is what you know now that the new purchasing agent is not obtaining competitive bids. Is this detection risk? First of all is this a detection risk, inherent risk or control risk? Well hopefully you know that if your purchasing agent is not having competitive bids it means they can select any purchase, any supplier they want to. It means you don't have good internal control. What does that mean? You don't have good internal control. It means it has to do with control risk. Is your control risk higher now or lower? Well guess what? It's higher because this individual I'm not saying I'm not saying they're doing anything wrong but they have the potential. If they're not obtaining competitive bids they can buy from any supplier they want therefore it's a control risk and it's going to increase the control risk. Now if you are told the opposite, if you are told we did not have competitive bids and now we do then that's going to reduce the control risk. It means the company have more control in terms of protecting their finances. So we're going to increase control risk because of that. And the good thing about this simulation each scenario is independent. So if you get the first one wrong you might get the second one right. Early in year two the company expanded its warranty program to cover additional major product in an effort to increase sales. So what they did is they increased their warranty program. Now is this a detection risk? Not really. The risk of not detecting error that has nothing to do with detection risk. So that's out. It's either control risk or inherent risk. Well we're not talking about any controls here. All what happens is the company is increased their warranty period. That's all what they do. And guess what? They increase their warranty period when they expand their warranty. Their warranty expense will have to be generally speaking will have to be increased. Warranty is an estimate. What happened now is you're making more estimates. As you make more estimate inherently the account becomes inherently more risky. Therefore what's going to happen is the inherent risk and the audit risk model will increase. Therefore it's an inherent risk and it's an increase in inherent risk. That's done. This one here. The audit partner decided that the audit team needed to perform additional test of details over payroll in addition to the substantive analytical procedure done last year over payroll. Okay. What are we saying here? We're saying that last year when we audited payroll we performed substantive analytical procedures. So we went and we did some analytical procedures. How many employees do we have? What did they earn per hour? What's the overtime? And we computed the number to make sure we are in good shape. This year what the audit says and the audit partner said now, we want to do test of details. We want to pull transaction, we want to test transaction over payroll. What is that going to do? First of all, once you hear the word test of detail, that's substantive testing. It means we are doing more work. It means we are trying to reduce our detection risk. Remember, if we do more work, the risk of making an error should go down. Okay. So it's not control risk because control risk has to do with the company. It's not inherent risk. You know, payroll, we don't care whether it's inherent account or inherently risky account or not. We're talking about doing more work, more test of details. So it has to do with our detection risk. Are we increasing our detection risk? Are we increasing our detection risk, the risk of not detecting something? Or are we reducing our detection risk? Here we are reducing. Why? Because we're doing more work. You do the less risk you are taking. Your detection risk goes down. Okay. In year two, the company budgeted for the creation of an internal audit department, which will commence operation in year three. What is the effect? Now, what is the effect in year two? Because you have to be very specific. The effect is on year two. There's no effect on year two yet. That's good news, but there's no effect on the audit for year two. For year three, if you are asked for year three, what do you think will happen? I would say if I have to guess, my control risk will go down. If they have an internal control audit department now, well, they have additional checks and balances within the company, which is good for you because as an auditor, the control risk should go down. But for year two, there is no effect because it doesn't take place until year three. But in year three, when we are giving this information, this should reduce our control risk. But in year three, the question is about year two. Okay. In January, year two, the corporate controller implemented a supervisory review of all internally prepared reconciliation. Wow. So we prepared reconciliation, but now we're going to, somebody's going to review the reconciliation. The auditor determined that the controls are designed and operating effectively for the period. Well, guess what? If they're doing more work, if the company is doing more work to protect their system, to protect their accounting information system, to protect the integrity of the transaction, it's good for the auditor because the control risk will go down. The control risk will go down. Why? Because now the company itself, they are trying to do properly perform their transaction, which will, should give me less work because it's not only they're doing reconciliation, they're asking somebody to review all internally prepared reconciliation. So that's basically a good news for the auditor. It makes their job easier. Why? The control risk should go down. So the control risk should go down, decrease in the control risk. As I mentioned from the beginning, each individual situation was independent. You should be happy to get a simulation like this. If you are comfortable with my audit risk model, if you, if you are comfortable with this lesson, this is easy. I'll bring it on. As always, I would like to remind you, you only study for your CPA ones. Invest properly. Subscribe. Go ahead to my channel. Subscribe. You'll have access to additional resources, practice, multiple choice lectures. Study hard. I'm always here to help you take this seriously because it's going to pay dividend in your career. Good luck.