Audit 1 – Financial Accounting – Flashcards
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Principals & Agents relationship leading to demand for auditors
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Agents- managers Principals- stockholders Conflict of interest Principal hires agents to manage resources. Agents hire auditors to report on fairness of FS. Auditors gather evidence & add credibility.
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Describe the relationship between internal controls, individual transactions, & account balances
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Internal controls are used to help prevent misstatements when recording transactions. Transactions are reported into accounts which have a balance (total) of all the transactions. Account balances are used to prepare the financial statements.
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Discuss how evidence regarding internal controls, individual transactions, & account balances can help an auditor determine if the financial statements are fairly stated.
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Sally Thompson's company, Sally's Shoes, is a successful shoe retail store with one store. Sally would like to expand to two locations, but the bank has asked for an independent audit before it will provide financing. Sally hires her brother-in-law, George Thompson, to perform the audit. George has experience in auditing non-profit organizations and he decides to perform the audit the same way as his other audits. After completing all the steps of the audit process, George issues an unqualified opinion indicating that he is certain that the company's financial statements contain no misstatements. Comment on any potential problems with George's audit of Sally's Shoes.
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Independence: brother in law; biased Competence: only has good experience in non-profit; needs an understanding of the industry; audit should not be performed the same as the other He cannot be certain because an unqualified report just gives assurance to material misstatements
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Explain the relationship between audit, attest and assurance services.
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Audit- form of attest services; objectively obtaining ; evaluating evidence regarding assertions about economic actions ; events to ascertain the degree of correspondence between those assertions ; established criteria ; communicating the results to interested users Attestation- practitioner is engaged to issue a report on subject matter or an assertion about subject matter that is the responsibility of another party Assurance- independent professional services that improve the quality of information or its context for decision makers All need evidence to give information
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The textbook presented the concept of auditing through an analogy that involved buying a house and hiring a house inspector. Name three desirable qualities of a house inspector or an auditor and discuss how those qualities apply to an auditor and why those qualities are important for an auditor to possess.
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A house inspector should have knowledge A house inspector should honest A house inspector should no be careless
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Discuss an overview of the financial statement audit process using the terms "assertion," "evidence," and "report."
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"evidence," and "report." The auditor gathers evidence about the business transactions that have occurred (economic activity and events) and about management (the preparer of the statements). The auditor uses this evidence to compare the assertions contained in the financial statements to the criteria chosen by the user. The auditor's report communicates to the user the degree of correspondence between the assertions and the criteria.
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You are a new employee at the accounting firm Murray & Murray, CPAs. Before you are assigned to your first audit, your supervisor tests your knowledge and asks you to explain the term "scope" in the context of a financial statement audit. Required: A. Provide a definition of scope. B. Describe what influences an auditor's determination of scope.
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A. Scope is the type ; amount of audit work that is to be done B. risk, materiality, ; evidence influence scope
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Why must an auditor assess materiality?
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It is not logical to test all transactions ; accounts. It would be too time consuming ; costly. An auditor focuses on misstatements that have high materiality meaning that they would affect the users decidions
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You are a new staff auditor and you are auditing a client's inventory account. Briefly describe one way you might obtain direct evidence and one way you might obtain indirect evidence that the inventory account balance is fairly stated.
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Direct- count physical inventory & match against inventory account Indirect- examine invoices from suppliers
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Name and discuss the seven phases of the audit process.
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1. Client acceptance/continuance and establish an understanding with the client 2. Preliminary engagement activities: Preliminary engagement activities include (1) determining the audit engagement team requirements and (2) ensuring the independence of the audit team and audit firm. 3. Plan the audit: The audit team must make a preliminary assessment of materiality and relevant risks. Then prepares a written audit plan that sets forth, in reasonable detail, the nature, extent, and timing of the audit work. 4. Consider and audit internal control: The auditor gains an understanding of internal control. 5. Audit business processes and related accounts: The auditor determines and performs individual audit procedures directed toward specific assertions in the account balance that are likely to be misstated. 6. Complete the audit: The auditor evaluates the sufficiency of the evidence gathered, assesses the possibility of contingent liabilities, and searches for any events subsequent to the balance sheet date that may impact the financial statements. 7. Evaluate results and issue the report: The auditor reaches a conclusion. Issues an report.
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A standard, unqualified auditor's report contains three paragraphs, plus a fourth explanatory paragraph in some circumstances. Provide a brief (one sentence) description for each paragraph.
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The introductory paragraph indicates which financial statements are covered by the report, that the statements are the responsibility of management, and that the auditor has a responsibility to express an opinion. The scope paragraph tells what an audit entails and how the audit was conducted The opinion paragraph indicates the auditor's opinion as to whether the financial statements are fairly presented in accordance with the criteria against which they were audited, GAAP. An explanatory paragraph is used to bring matters of importance to the reader's attention.
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Explain the relationship between sample size, materiality and desired level of assurance.
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The size of a sample is influenced by the materiality and the desired level of assurance for the account or assertion being examined. There is an inverse relationship between sample size and materiality and a direct relationship between sample size and the desired level of assurance
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Assertions about classes of transactions ; events for the period under audit:
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Occurrence - transactions have occurred ; pertain to the industry Completeness- have been recorded Authorization Accuracy- recorded appropriately Cutoff- correct accounting period Classification- proper accounts
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Assertions about account balances at the period end:
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Existence- assets, liabilities, ; equity interests exist Rights ; obligations- entity holds or controls assets ; liabilities are obligations of the entity Completeness Valuation ; allocation- amounts adjusted appropriately
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Assertions about presentations ; disclosures:
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Occurence ; rights ; obligations- disclosed events Completeness Classification ; understandability- financial info is appropriately presented ; disclosures clearly expressed Accuracy ; valuation
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Audit risk
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the risk that the auditors expresses an inappropriate audit opinion when the financial statements are materially misstated; auditor only provides reasonable assurance
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Audit evidence regarding management assertions
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Consists of underlying accounting data ; additional information available to the auditor Relevence Reliability
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Audit Report 3 types
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Unqualified- clean audit report; financial statements are free of material misstatements, auditor does not find it necessary to qualify opinion about the fairness of the financial statements Qualified- financial statements are fairly stated except for the misstatements identified by the auditor; misstatement is considered material ; management refuses to correct it Adverse- the financial statements are not fairly stated ; should not be relied upon; when misstatements are so material that it affects the interpretation of the financial statements
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Name two account balance management assertions pertaining to inventory and explain why they are considered in an audit.
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Existence: physical examination tests can be done;sometimes inventory is overstated Completeness: inventory may not include everything that should have been recorded
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Define corporate governance, the board of directors, and the audit committee and explain how they relate to each other.
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Corporate governance- all the people, processes, ; activities in place to help ensure proper stewardship over an entity's assets Board of Directors- the body primarily responsible for management oversight in corporations Audit committee- oversees internal & external audit work done for an entity Board of directors controls corporate governance. The audit committee is made up of members from the board of directors
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List the organizations involved in standard setting for auditors
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Securities & Exchange Commission (SEC) Financial Accounting Standards Board (FASB) International Auditing & Assurance Standards Board (IAASB) Public Company Accounting Oversight Board (PCAOB) American Institute of Certified Pubic Accountants (AICPA) Institutional Accounting Standards Board (IASB)
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What are the three general auditing standards found within the 10 GAAS (NOT the three main categories of GAAS) and why is each important?
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1. Adequate training & proficiency 2. Maintain independence 3. Due Professional Care- degree of skill
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Jane Goodperson performed an audit on the Quagmire Corporation and issued an unqualified opinion. Jane performed the audit with due professional care and in accordance with generally accepted auditing standards. Two months after the report is issued, Jane discovers on the news that the CEO of Quagmire, Johnny Best had been stealing small amounts of inventory. The amount, however, is immaterial compared to the overall inventory of the corporation. Jane soon receives a call from Quagmire's CFO, Mark Beastly. Mark wants Jane to refund her audit fees. Mark thinks Jane did not properly perform the audit, as she did not discover this fraud. Further, he feels that now Quagmire's financial statements are not fairly stated because of Jane. How should Jane respond to this claim?
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Jane should tell Mark that her responsibility was to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud. She had no responsibility to plan and perform the audit to obtain reasonable assurance that misstatements, whether caused by errors or fraud that are not material to the financial statements will be detected. Quagmire's management, not Jane, has responsibility for the financial statements. In fact, because of the Sarbanes-Oxley Act of 2002, Mark had to take explicit responsibility for the financial statements by "certifying" that he as CFO is responsible for establishing and maintaining internal control and that the financial statements fairly present the entity's financial conditions and operations. This statement is probably still true, since the amount stolen was immaterial.
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Mike has just graduated from State University with a bachelor's degree in accounting. He would like to pursue a career in auditing. What options does Mike have? Describe three auditing career options, including a description of the organization Mike would work for.
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External: work for a CPA firm providing independent audits to nonpublic or public companies; need to pass the Uniform CPA Exam Internal: directly employed by the entity on which he is performing audits. Governmental: This is essentially a form of internal auditing and Mike could be employed by federal (such as the Government Accountability Office or the Internal Revenue Service), state, or local agencies. Forensic: fraud
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With respect to an entity's financial statements, describe both the responsibility of management and of the auditor.
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The financial statements are the responsibility of management. The auditor's responsibility is to express an opinion on the financial statements based on the audit.
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What auditing standards are used to conduct an audit for a privately-held corporation? What auditing standards are used to conduct an audit for a publicly held-and-traded corporation? What organization is responsible for setting each of these sets of standards?
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Privately-held: Auditing Standards Board Public: PCAOB
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There are several types of audit services that are provided by auditors. Identify and define three of these types of audits.
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Financial Statement Audit: Auditors test the transactions, balances, and disclosures in a set of financial statements to determine if they are materially correct. Internal Control Audit: Auditors test the internal controls of a company to determine whether the control system is functioning effectively (i.e. preventing, detecting, and correcting misstatements in the financial statements). Forensic Audit: Auditors conduct forensic audits to detect or deter fraudulent activities.
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Audit Teams ; what they do
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Partner- agreement with auditee, plan audit, assemble team Manager- ensure plan is proper, schedule team members, review audit report, collection of payments Senior- assist audit plan, budgets, assign tasks to staff, supervise staff Staff- perform audit procedures, prepare documentation for completed work
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Business Processes (5)
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Financial Purchasing Human Resource Management Inventory Management Revenue
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GAAS 3 main parts
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General Field Work Reporting
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Standards of field work
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1. Adequate planning ; supervised assistants 2. Obtain sufficient understanding of internal controls (nature, time, extent) 3. Obtain sufficient appropriate evidential matter
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Standards of Reporting
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GAAP Consistency- across perios Disclosures Opinion
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Principles underlying an audit
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Purpose- to express an opinion on FS prepared by management Responsibilities- competence ; capacity; comply with ethical requirements; professional skepticism; professional judgement Performance- sufficient audit evidence supporting reasonable assurance Reporting- express an opinion based on the evidence evaluated
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Ethics ; Professionalism
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Ethics- a system or code of conduct based on moral duties ; obligations that indicate how we should behave Professionalism- the conduct, aims, or qualities that characterize a profession or professional person
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Code of Conduct (3)
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Principles Rules of Conduct Interpretations of the Rules
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Why do professions establish codes of conduct that define ethical behaviors for members of the profession?
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Users know what to expect Behavior acceptable Use rules to monitor actions
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Distinguish between the following theories of ethical behavior: utilitarianism, a rights-based approach and a justice-based approach.
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Utilitarianism- recognizes that decision making involves traded-offs between the benefits ; burdens of alternative actions ; focuses on consequences ; on individuals affected Rights-based approach- assumes that individuals have certain rights ; other individuals have a duty to respect those rights when making decisions Justice-based approach- in concerned with issues such as equity, fairness, ; impartiality
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Which professional and regulatory bodies establish the ethical and professional rules for auditors of public companies? private companies?
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Private- AICPA ; ISB Public- PCAOB, SEC ; ISB
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Due care
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A member should observe the profession's technical and ethical standards, strive continually to improve competence and the quality of services, and discharge professional responsibility to the best of the member's ability
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Responsibilities
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Members should exercise sensitive professional and moral judgments in all their activities
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Objectivity ; independence
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A member should be free of conflicts of interest in discharging professional responsibilities
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Scope ; nature of services
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A member in public practice should observe the Principles of the Code of Professional Conduct in determining the type and extent of services to be provided
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Public interest
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Members should accept the obligation to act in a way that will honor the public trust and demonstrate commitment to professionalism
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Integrity
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To maintain and broaden public confidence, members should perform all professional responsibilities with the highest sense of ______________
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Holding out
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Any action initiated by a member that informs others of his or her status as a CPA or AICPA-accredited specialist.
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Attest engagement
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Examples include financial statement audits, reviews, and examinations of prospective financial information.
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Ms. Lembke is a partner for DTS, a CPA firm. She is the lead partner for the firm's largest client, The Grey Elephant. Ms. Zadina, who works in the same office as Ms. Lembke, has a sister who is the controller for The Grey Elephant. Because of potential independence issues, Ms. Zadina does no work for The Grey Elephant. Ms. Zadina is being considered for promotion to partner. What independence issues should Ms. Lembke consider before promoting Ms. Zadina?
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Interpretation 101-1 of the AICPA Rules of Conduct states that all partners of a firm must be independent of any attestation clients of the firm. Therefore, if Ms. Zadina is promoted to partner, DTS would no longer be able to provide attestation services for The Grey Elephant. If Ms. Zadina is promoted, she will have to move to another office or DTS will have to give up their largest client.
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The SEC's rules with respect to services provided by auditors are predicated on three basic principles of auditor objectivity and independence. What are the three basic principles?
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(1) an auditor should not audit his or her own work (2) an auditor should not function in the role of management (3) an auditor should not serve in an advocacy role for his or her client.
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When can a CPA disclose confidential information without the client's consent?
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(1) to meet disclosure requirements for GAAP or GAAS (2) to comply with a valid subpoena (3) as required by an authorized peer review body (4) investigative or disciplinary proceeding (5) in connection with the purchase, sale, or merger of the practice.
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Principles of professional conduct
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Responsibilities The public interest Integrity Objectivity & independence Due car Scope & nature of services
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Rule 101
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"covered members" must be independent If a partner or professional leaves a firm to work at a client's office, the relationship is no impaired
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Covered Members
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An individual on the attest engagement team An individual in a position to influence the attest engagement A partner or manager who provides nonattest services to the attest entity beginning once he or she provides 10 hours of nonattest services A partner in the office in which the lead attest engagement partner primarily practices in connection with the attest engagement The firm, including the firm's employee benefits plan An entity whose operating, financial, or accounting policies can be controlled by any of the individuals or entities described above or by two or more such individuals or entities if they act together
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Direct Relationship
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A financial interest that is owned directly by an individual or entity, or is under the control of an individual or entity
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Material Indirect Relationship
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Results when a covered member has a financial interest in an entity that is associated with an attest entity, for example an investment in a mutual fund that owns the entity's stock
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9 Categories of Prohibited Nonaudit Services
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Bookkeeping Actuarial Services Broker or Dealer Financial Info Systems Design ; Impl Internal Audit Outsourcing Services Legal Services Appraisal or Valuation Management Functions or HR Expert Services
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Rule 102
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In the performance of any professional service, a member shall maintain objectivity and integrity, shall be free of conflicts of interest, and shall not knowingly misrepresent facts or subordinate his or her judgment to others
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Rule 201
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A member shall comply with the following standards and with any interpretations thereof by bodies designated by Council. Professional Competence Planning ; Supervision Due Professional Care Sufficient Relevant Data
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Rule 202
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Requires that members of the AICPA comply with professional standards when performing professional services, whether or not they are practicing in public accounting.
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Rule 203
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A member shall not (1) express an opinion or state affirmatively that the financial statements or other financial data of any entity are presented in conformity with GAAP or (2) state that he or she is not aware of any material modifications that should be made to such statements or data in order for them to be in conformity with GAAP, if such statements or data contain any departure from an accounting principle promulgated by bodies designated by Council to establish such principles that has a material effect on the statements or data taken as a whole.
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Rule 301
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A member in public practice shall not disclose any confidential client information without the specific consent of the client.
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Rule 302
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A member shall not (1) Perform for a contingent fee any professional service for, or receive such a fee from, a client for whom the member or the member's firm performs (a) an audit or review of a financial statement, (b) a compilation of a financial statement expected to be used by a third party if the compilation report does not disclose a lack of independence, or (c) an examination of prospective financial information, or (2) Prepare an original or amended tax return or claim for a tax refund for a contingent fee for any client.
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Rule 501
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A member shall not commit an act discreditable to the profession.
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Rule 502
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A member in public practice shall not seek to obtain clients by advertising or other forms of solicitation in a manner that is false, misleading, or deceptive. Solicitation by the use of coercion, over-reaching, or harassing conduct is prohibited.
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Rule 503
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Prohibited Commissions: A member in public practice shall not for a commission recommend or refer to a client any product or service or receive a commission, when a member or the member's firm also performs for that client (a) an audit or review of financial statements, (b) a compilation of financial statements expected to be used by a third party and the compilation report does not disclose a lack of independence, or (c) an examination of prospective financial information. Disclosure of Permitted Commissions: A member in public practice who is not prohibited by this rule from performing services for or receiving a commission and who is paid or expects to be paid a commission shall disclose that fact to any person or entity to whom the member recommends or refers a product or service to which the commission relates. Referral Fees: Any member who accepts a referral fee for recommending or referring any service of a CPA to any person or entity or who pays a referral fee to obtain a client shall disclose such acceptance or payment to the client.
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Rule 505
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A member may practice public accounting only in a form of organization permitted by law or regulation whose characteristics conform to resolutions of Council. A member shall not practice public accounting under a firm name that is misleading. Names of one or more past partners may be included in the firm name of a successor organization. A firm may not designate itself as "Members of the American Institute of Certified Public Accountants" unless all of its CPA owners are members of the Institute.
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Disciplinary Actions (PEEC) trial board actions
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Termination of AICPA Membership Suspend AICPA Membership
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Elements of Quality Control
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1. Leadership: tone at the top 2. Relevant Ethical Requirements 3. Acceptance ; Continuance of Entity Relations 4. Human Resources 5. Engagement Performance 6. Monitoring
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Jeff Johns is a staff accountant and has been assigned to the audit of Worldwide Enterprises, Inc. Subsequent to the completion of fieldwork Jeff was assigned to draft the audit report. The content of one of the paragraphs he has drafted reads as follows: As explained in Note 2 to the financial statements, Worldwide Enterprises has charged goodwill and certain other intangible assets acquired in two separate acquisitions directly to shareholders' equity. Under generally accepted accounting principles, these intangibles should have been recorded as assets and amortized to income over future periods. Had these intangibles been capitalized, total assets would have increased by $400,000 as of December 31, 2009 and net income and earnings per share would be increased by $380,000 and $2.25, respectively (assuming a 20-year amortization period). a. Based on the contents of the paragraph above, which condition requiring a departure from a standard unqualified opinion exists in the engagement? b. Assuming that the engagement partner agrees with the paragraph Jeff has prepared above, where in the auditor's report should the paragraph be placed? c. How would the materiality of the condition above affect the final choice of opinion?
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A. Indicates a departure from GAAP; either qualified or adverse opinion depending on the materiality B. If qualified or adverse, a paragraph should be placed before the opinion paragraph C. A material misstatements needs a qualified opinion. A pervasively material misstatements needs an adverse opinion.
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The following four situations require a modification to the standard unqualified audit report. Identify the modification required for each. a. Opinion based in part on the report of another auditor b. Going concern c. Lack of consistency d. Emphasis of a matter
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a. This situation results in a modification of the wording for the three paragraphs included in the standard report b. This situation results in an explanatory paragraph found after the opinion paragraph c. This situation results in an explanatory paragraph found after the opinion paragraph d. This situation results in an explanatory paragraph found after the opinion paragraph
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Changes in a client's accounting choices either affect "consistency" in the application of GAAP or they do not. For each item listed below, state whether the item affects consistency and identify the effect the change will have on the audit report. 1) Change in accounting estimate 2) Correction of an error in principle 3) Change in reporting entity 4) Correction of an error that does not involve an accounting principle 5) Change in accounting principle 6) Change in classification and reclassification 7) Change expected to have a material future effect
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1) does not affect consistency and no modification to the audit report is required 2) affects consistency and an explanatory paragraph 3) affects consistency and an explanatory paragraph 4) does not affect consistency and no modification to the audit report is required 5) affects consistency and an explanatory paragraph 6) does not affect consistency and no modification to the audit report is required 7) does not affect consistency and no modification to the audit report is required
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For each of the following situations, indicate what type of audit report is most appropriate. a. The auditor lacks independence in fact, but not necessarily in appearance b. There is a scope limitation and it is material but the overall financial statements are still presented fairly. c. The uncorrected misstatements are immaterial d. There is a departure from GAAP and it is pervasively material
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a. Disclaimer b. Qualified c. Unqualified d. Adverse
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Discuss the conditions that prohibit the auditor from issuing an unqualified opinion and the types of reports that the auditor may issue for a financial statement audit.
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1. Scope limitation. A scope limitation results from an inability to collect sufficient appropriate evidence, such as when management prevents the auditor from conducting an audit procedure considered necessary. *QUALIFIED REPORT 2. Departure from GAAP. The financial statements are affected by a departure from GAAP. *ADVERSE REPORT 3. Lack of auditor independence. The auditor must comply with the second general standard and the Code of Professional Conduct in order to issue an unqualified opinion. *DISCLAIMER REPORT
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Standard Unqualified Report List 8 Elements Used when?
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Report Title Addressee Introductory paragraph Scope paragraph Opinion paragraph Explanatory paragraph Name of auditor Audit report date When the auditor has gathered sufficient evidence, the audit has been performed in accordance with PCAOB standards, and the financial statements conform to GAAP
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Standard Unmodified Report List 9 Elements Used when?
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Report Title Addressee Introductory paragraph Management's responsibility Auditor's responsibility Scope paragraph Opinion paragraph Name of auditor Audit report date When the auditor has gathered sufficient evidence, the audit has been performed in accordance with GAAS, and the financial statements conform to GAAP
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When to use explanatory paragraph?
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1. Reference to report on audit of ICFR 2. Going conern 3. Lack of consistency 4. Additional emphasis
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When to use modified wording?
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Opinion based in part on the report of another auditor
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Changes affecting consistency
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Change in accounting principle Change in reporting entity Correction of a misstatement in FS NOT: Change in accounting estimate Change expected to have material future effect Change in classification & reclassification
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Additional Emphasis
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An auditor may want to emphasize a specific matter regarding the financial statements even though he or she intends to express an unqualified/unmodified opinion. Explanatory paragraph
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Disclaimer
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No opinion is expressed; insufficient appropriate evidence to form an opinion on FS or lack of independence
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Pervasive effects on the financial statements are those that:
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Are not confined to specific elements, accounts, or items of the financial statements; If so confined, represent or could represent a substantial proportion of the financial statements; or With regard to disclosures, are fundamental to users' understanding of the financial statements.
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What is the difference between audit risk and engagement risk?
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Audit risk is the risk that the auditor may unknowingly fail to appropriately modify the opinion on financial statements that are materially misstated Engagement risk is the auditor's exposure to loss or injury to professional practice from litigation, adverse publicity, or other events arising in connection with financial statements audited and reported on
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Your classmate asserts, "Accountants shouldn't need to take business courses besides accounting, because they are only interested in the financial statements of a company." Defend or refute this statement.
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Auditors need to develop a deep understanding of business. Most business concepts and risks have the potential to affect the financial statements either immediately or in the long run Increases the likelihood of identifying material misstatements in the financial statements
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You are the senior on an audit of Two Be Gone, a large publicly held company. The company recently completed an acquisition of its fifth largest competitor. What risks might this present? How will you, the auditor, respond to these risks (i.e. what actions should you take)?
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Risks??? After identifying possible risks, the auditor should determine which ones may result in material misstatements in the financial statements & evaluate these risks
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Define misstatements arising from fraudulent financial reporting and misstatements arising from misappropriation of assets in one sentence each.
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Misstatements arising from fraudulent financial reporting are intentional misstatements or omissions of amounts or disclosures in financial statements intended to deceive financial statement users. Misstatements arising from misappropriation of assets involve the theft of an entity's assets where the theft causes the financial statements to be misstated.
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DATRIX, Inc, a Fortune 500 company, has been experiencing poor performance. Industry analysts have been issuing negative reports and the company's stock price has been steadily declining. As an auditor, what would concern you about the audit engagement of DATRIX, Inc.
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An auditor should be concerned because of the apparent incentive the management of DATRIX may have to commit financial statement fraud. For instance, the company's management may be tempted to change accounting estimates or use other means to falsely increase the company's book profits. The auditor should exercise professional skepticism in this engagement and addresses carefully the risk of financial statement fraud.
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During the course of the audit of FF Financial, you find that some accounting entries have been altered. You believe this may be the result of management fraud and you have determined that the effect of this could be material to the financial statements. What are appropriate steps to take?
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In this situation, the auditor should attempt to obtain audit evidence to determine whether material fraud has occurred and, if so, its effect. If fraud is found in one account, there are chances the auditor will find fraud in other accounts, as well. The auditor needs to discuss the matter and the approach to further investigation with an appropriate level of management that is at least one level above those involved in committing the fraud and with senior managements.
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Often in an audit, total combined tolerable misstatement is greater than overall materiality. Why is this the case?
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Not all accounts will be misstated by the full amount of their tolerable misstatement allocation When control weaknesses or misstatements are identified in an account, the auditors typically perform additional procedures in that and related, accounts. Thus, the actual testing will often achieve a much smaller margin for misstatement than planned tolerable misstatement
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Prospective Client Acceptance
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Obtain and review financial information. Inquire of third parties regarding client integrity. Consider unusual business or audit risks. Determine if the firm is independent. Determine if the firm has the necessary technical skills and knowledge. Determine if acceptance violates any applicable regulatory agency requirements or the Code of Professional Conduct.
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Continuing Client Retension
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Evaluate client retention periodically near audit completion or after a significant event 1. Conflict over accounting & auditing issues 2. Dispute over fees
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Preliminary Engagement Activities
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1. Determine the audit engagement team requirements 2. Assess compliance with ethical & independence requirements 3. Establish understanding with entity
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In establishing the terms of the engagement, three topics must be discussed:
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1. The engagement letter 2. Using the work of the internal audit function 3. The role of the audit committee.
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Engagement Letter includes:
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1. Objectives of the engagement 2. Management's responsibilities 3. Auditor's responsibilities 4. Limitations of the engagement MAY INCLUDE: 1. Specialist use arrangements 2. Additional services
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Engagement Letter
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Formalizes the arrangement reached between the auditor and the client.
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Internal Audit Function
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Objectivity- extent to which the IAF's status & policies & procedures support the objectivity of internal auditors Competence- level of competence of the IAF Systematic- application of IAF of a systematic & disciplined approach including quality control
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Section 301 of Sarbanes-Oxley Act requires the following for audit committee members of PUBICALY held companies: PRIVATE?
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Member of board of directors and independent. Directly responsible for overseeing work of any registered public accounting firm employed by the company. Must preapprove all audit and nonaudit services provided by its auditors. Must establish procedures to follow for complaints. Must have authority to engage independent counsel. PRIVATE: none
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Planning the Audit Steps
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1. Assess business risks. 2. Establish materiality. 3. Consider multilocations. 4. Assess the need for specialists. 5. Consider violations of laws and regulations. 6. Identify related parties. 7. Consider additional value-added services. 8. Document the overall audit strategy, audit plan, and prepare audit programs.
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Why do we assess business risks?
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To understand the entity's business & transactions To identify financial statement accounts likely to contain errors The auditor can allocate more resources to investigate more risky accounts
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Direct & Material Illegal Acts
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Consider laws and regulations as part of audit
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Material & Indirect Illegal Acts
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Be aware of what may have occurred; investigate if brought to attention
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Information or circumstances that may indicate an illegal act
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Unauthorized transactions Large payments to unspecified events Failure to file tax returns An investigation by a government entity
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"Related Party Disclosures"
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Affiliates of the enterprise. Entities using equity method to account for investments. Trusts for benefit of employees. Principal owners of enterprise. Management. Immediate families of the principal owners and management. Other parties that can have significant influence.
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How to Identify Related Parties
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Review board minutes. Review conflict-of-interest statements. Financial and reporting information provided to creditors, investors, and regulators. Contracts or other agreements with major customers, vendors, and management. Review significant unusual transactions.
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Additional Value-added Services
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Tax planning Risk Assessment Benchmarking Electronic Commerce Internal Reporting System Design & Integration Auditors who audit public companies are limited in the types of consulting services that they can offer their auditees. NEVER MAKE MANAGEMENT DECISIONS ONLY ADVICE
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Document overall audit strategy and audit plan, which involves documenting the decisions about:
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Nature Timing Extent
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Engagement partner and other supervisory members of the team:
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Inform engagement team members of their responsibilities Direct engagement team members to identify and communicate audit issues Review the work of the engagement team members
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Risk Assessment Procedures are used to
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obtain an understanding of the entity and its environment, including its internal control.
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Tests of Controls
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Directed toward the evaluation of the effectiveness of the design and operation of internal controls.
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Substantive Procedures
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Detect material misstatements in a transaction class, account balance, and disclosure component of the financial statements. Looking at transactions & tracing them to financial statements then confirm material amounts on accounts
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List Tests of Controls (5)
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Inquiry Observation Inspection Walkthrough Reperformance
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2 Substantive Procedures
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Tests of Details Analytical Procedures
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Tests of Detail
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Tests for errors or fraud in individual transactions, account balances, and disclosures
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Analytical Procedures
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Evaluations of financial information through analysis of plausible relationships among financial and non-financial data Trends & ratios
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Dual-Purpose Tests
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Tests of controls Substantive tests of transactions *PCAOB does not like this
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Substantive Test
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Tests for errors & fraud
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Steps in Applying Materiality on an Audit
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1. Determine overall materiality 2. Determine tolerable misstatement 3. Evaluate audit findings
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Determine Materiality (quantitative)
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Percentage of: Income (loss) before taxes. Income from continuing operations. Three year average income. Total assets. Net assets. Total revenues. Gross profit. Total equity
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Determine Materiality (qualitative)
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Material misstatements in prior years. High risk of fraud. Potential loan covenant violations. High market pressures. Volatile business environment. Higher than normal risk of bankruptcy.
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Tolerable Misstatement
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The amount of planning materiality allocated to an account or class of transactions
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Combined tolerable misstatement is generally greater than planning materiality because:
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Not all accounts will be misstated by their full tolerable misstatement allocation. Audits of individual accounts are conducted simultaneously. Materiality is often a small fraction of the account being audited and planned procedures will be sufficiently precise to identify significant misstatements. When errors are identified, additional testing is typically performed in that account and related accounts. Overall materiality serves as a "safety net."
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When the audit evidence is gathered, the auditor:
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Aggregates misstatements from each account or class of transactions (including known and likely misstatements). Considers the effect of misstatements not adjusted in the prior period. Compares the aggregate misstatement to overall materiality. If the aggregate misstatement is less than overall materiality, the auditor can conclude that the financial statements are fairly presented, if not, an adjustment should be made.
