 Hello and welcome to the session in which we would look at a CPA exam simulation that could appear on the auditing and attestation exam. The first thing you do when you are faced with a CPA exam simulation is to take a look at the simulation itself. What am I dealing with? If you look down here, you are dealing with a drop-down menu because this is one type of simulation. It could be a drop-down menu. It could be journal entry simulation. It could be simulation where you have to perform some computation. It could be a research simulation. It could be a document review simulation. Well, this is a drop-down menu. Good. This is the type. The second thing you do is you want to kind of nail down the audit topic of the simulation. What is the topic of the simulation? Look, if I look in this, in this drop-down menu, I'm looking at control risk, detection risk, inherent risk. Well, if you know anything, this has to do with the audit risk model. Immediately, you should be thinking, great, I understand my audit risk model. I understand its component. I understand the relationship between the various audit risk model, especially if I'm using for-hat lectures to prepare for the exam. Bring it on. I'm ready to answer these questions. Good. Now you would read what you are giving and you will try to answer the questions. Before we proceed any further, I have a public announcement about my company, farhatlectures.com. Farhat accounting lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course, such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses, broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions, as well as exercises. Go ahead, start your free trial today. Let's go ahead and get started. Best wood furniture ink, an unassured that produces wood furniture is undergoing a year-to-audit. The situations below describe changes made during year two. Be careful which year you are dealing with that may or may not contribute to the audit risk. Well, the audit risk is what? Inherent risk, times control risk, times detection risk. For each situation, select the impact, if any, that the situation has on a specific component of the audit risk for year two audit. Selection might be made once, more than once, or not at all. Consider each situation independently. This is great. I have one, two, three, four, five independent situation. So if I get too wrong, I may get three right. If I get three right, I may get four right, five wrong. Each one is independent. Now, how would you be able to answer the simulation? Well, if you don't know what inherent risk, what control risk or what detection risk is, you won't be able to answer the simulation. It's not because the simulation is difficult. It has nothing to do with the simulation. This simulation, you're going to see it's an easier than a multiple choice. The problem is not the simulation. The problem is your understanding of the audit risk model and the audit risk component. I keep emphasizing this point, because the main complaint I receive is, well, how do I prepare for simulations? Well, know the topic and you'll be prepared for the simulation. So let's real quick go over control risk. What is a control risk? Because here we have to know whether the situation increase control risk or decrease control risk. Well, control risk is a risk that a misstatement could occur, could happen, and the internal control will not prevent this misstatement from happening. It will not prevent, detect or correct. So a statement will happen, and it will go undetected by the internal control. That's what control risk is. What is detection risk? This risk, this risk is, is when the auditor procedures, when the auditor auditing procedures fails to detect material misstatement, will not detect material misstatement. So if you are employing effective detection measures, if you are employing effective audit procedures, if you are employing experience auditor, your detection risk should go down. Your detection risk should go down. However, if you are not performing enough procedures, if you are employing less experience individual, if you are not familiar with the industry or the company, your detection risk will go up. And what is inherent risk? Again, you don't want to think about those on the exam day. You would need to know those inside out and how they all relate to each other. What is inherent risk? It's the likelihood of a material misstatement in the financial statement due to the nature of the business or the transaction without taking into account internal control. Simply put, the account itself or the transaction itself is risky by its nature. What will be, what will be an example of this? Well, for example, if you are dealing with complex financial transaction that involves derivatives, but inherently, this is an inherent account and inherent risky transaction. If the transaction requires judgment, estimate, it's inherently risky because you are making a guess, an educated guess. Once that estimate gets involved in a transaction, inherent risk will go up. Now, again, we're wasting a few minutes explaining this. You don't want to do this on the exam day. Okay, so let's take a look at what we are told. Again, each situation is independent. In year two, the auditor noted that the company's newly hired purchasing agent was not obtaining competitive bids for all major purchase requisition as required. Hold on a second. This has to do with the internal processes of the company. What is the internal process? What's the process? The process is the purchasing agent will need to obtain competitive bids. So the purchasing agent cannot just select the supplier because they like them or for whatever reason, maybe they're only selecting good supplier. Nevertheless, we are not following the procedures, the internal control procedures, which is what? Obtaining competitive bids. Before we select a buyer, we have to obtain competitive bids. Otherwise, we could abuse the system. There's a potential of this purchasing agent abusing the system for their own benefit. What are we dealing with? We are dealing with an internal control situation. Well, internal control. Is this going to increase internal control? Or it's going to decrease internal control or control risk. It's going to increase control risk. Why? Because we are not following auditing procedures. And as a result, the risk of a material misstatement happening is high because we are not following procedures. Why? Because the purchasing agent could be benefiting their spouses, relative friends. And this is a risk, a control risk for the company. Early year two, the company extended its warranty program to cover additional major product in an effort to increase sales. So what did the company do? It said, you know what? Let's stimulate sales. How so? Let's increase the warranty program. This way, people are more likely to buy our product. That's a great. Why not? It's a good business procedure, good business plan. Is this a control risk, a detection risk, or an inherent risk? Well, let me tell you, detection risk has to do with auditing procedures. It has nothing to do with detection risk. Is it a control risk? Well, this is not really part of the procedure. This is a strategy that we are using. I would say this is inherent risk. Why? Think about when you expand your warranty program. What do you have to do when you have warranties? When you have warranties, you have to estimate your warranty expense. So you have to guess what's going to be the reserve, the warranty reserve, which is it's a form of an estimate into the future. Well, we are involving an estimate. It's not only an estimate. We are making an estimate further into the future. And because of that, we are increasing the inherent risk of this transaction or of this account. Therefore, it's going to increase inherent risk. The audit partner decided that the audit team needed to perform additional tests of details over payroll in addition to the substantive analytical procedures done last year over payroll. Now, what am I dealing with here? I'm dealing with detection risk. How do I know this? Well, if you read what's given, it's basically the partner is asking us to do more testing, test of details. It's a form of obtaining evidence. So we're dealing with what? Dealing with detection risk. So what is the auditor asking for? The auditor is asking for more work. Last year, we only performed analytical procedures, which is a very important concept to learn for the exam. And if you go to far hat lectures, I cover in details every cycle in details and political procedure. I also have a tutorial, basically a few lessons about analytical procedures, then I will take those tutorials and apply them in each cycle separately, including the payroll. So if the audit partner is asking us to do more work, well, is what is that? How is that going to affect detection risk? It's going to lower our detection risk. It's going to lower it. It's going to decrease. Now, why? Because we are taking more steps not to let something slip through. It's going to decrease our detection risk. So performing additional substantive procedures, which is test of details on a class of transaction such as payroll will detect will reduce our detection risk would reduce our detection risk in year two. The company budgeted for the creation of an internal audit department, which will commence operation in year three. Great. We are creating an internal audit department. That's a great. How is that going to affect the company audit risk, where it's going to affect the control risk? Because this is additional procedures done inside the company. It means we have strengthened, we are going to strengthen our internal control procedures, which in turn lower our control risk. The only thing you need to be aware of here, this department will not exist until year three. And we are dealing with the audit risk in year two. Well, really no impact, no impact on audit risk in year two. Now, the correct answer is no impact. But in the real world, what's going to happen is this. Let me, let me just, let's think about it. Although the correct answer is no impact, I just want to kind of make you think about it from a business perspective. Once the company make that decision and make that decision throughout all the departments, all the people in those departments, they'll put their act together because they know commit starting in year three, someone's going to be looking over their shoulders. So in theory, it will reduce the internal control risk in year two, but we cannot make that judgment. But the point is it should definitely in year three, if this question is about year three, no, if it's about it, it will lower control risk. But year three, no effect here. January year two, the corporate controller implemented a supervisory review of all internally prepared reconciliation. Oh, wow. So, so we have reconciliation in which is good. It's a form of internal control. It's not only that the corporate controller wanted to review all internally prepared reconciliation, the auditor determined that the control are designed, the auditor determined that the controls are designed and operating effectively for the period. Well, we even have even more, more evidence that everything is working properly. Well, what is that going to affect? It's going to affect our internal control procedures, which is has to do with our control risk. Is this going to increase our control risk or reduce our control risk? Well, on the contrary, not on the contrary, it's going to reduce our control risk. Now our internal control is working better. Control risk will go down. Basically, again, a simulation like this, I'm not sure how long it took maybe took me 15 minutes to answer these questions because I wanted to go over each question separately in the tails. But on the exam day, you know, inherent risk, control risk, detection risk. And here, they're not even asking you how they relate to each other. You want to know how they relate to each other. I am not going to go over this now because I do have an audit risk model, one whole lecture or couple lectures plus plus more exercises about this on fourhatlectures.com. But I wanted to show you that simulations are no more than a multiple choice question. For example, I can take this, this question here. And I say in year two, the auditor noted the company's newly hard purchasing agent was not obtaining competitive bits for all major purchase requisition as required. Is this, A, an increase in control risk, B, decrease in control risk, C, increase in inherent risk, D, decrease in or no impact on audit risk. It's a multiple choice. Don't let simulation intimidate you. The only reason simulations are difficult, because you don't understand the audit risk model in this situation or any other topic. Fourhat Lectures is always here for you. Good luck, study hard, stay confident and stay safe.