CPA Audit – Audit Engagement Field Work – Flashcards

Substantive testing can include the following: 1. Substantive tests of transactions - Examining the individual transactions within an account. This procedure is often performed in testing income statement accounts. 2. Tests of details of balances- Examining the ending balance of an account. This procedure is often performed in testing of balance sheet accounts. 3. Analytical procedures - An overview of a client's financial statement balances, using ratios and percentage comparisons and looking for either support or variances with expected figures and items that may warrant further investigation.

Generally, the best quality audit evidence is any direct evidence acquired first hand by the auditor, especially if it is information obtained from outside of the client company.

Detection risk can be reduced to a lower level by the following: 1. Performing more substantive testing than was originally planned. 2. Performing testing that obtains evidence of better quality. Better quality evidence is gained when the testing is carried out closer to the year-end, is performed by more experienced members of the audit staff, and/or uses more sophisticated audit techniques, such as positive confirmations and statistical sampling.

The auditor must seek evidence as to whether the company can remain in business for a minimum of at least 12 months form the balance sheet date.

Substantive testing is conducted in order to reduce detection risk for an account balance or a group of accounts such that actual audit risk for one or more management assertions is reduced to an acceptable level.

The subsequent period is the time between the balance sheet date and the date the audit report is issued. This period of time is often six to ten weeks in length.

Normally, when an auditor takes an ending account balance and vouches backwards into the accounting system for support or documentation, the auditor is seeking to substantiate the existence assertion. The auditor wants to find evidence to indicate that the recorded transaction actually occurred.

When an auditor takes evidence of a transaction and follows the documentation through the entire accounting information system, the auditor is attempting to substantiate the completeness assertion. The auditor wants to make sure that no portion of the transaction was lost within the accounting information system.

Without a letter of representation, an auditor cannot provide an unqualified opinion audit report. Lack of a letter of representation is a material lack of evidence and, thus, leads the auditor to issue either a qualified audit opinion because of a scope limitation or a disclaimer of opinion. The auditor could also withdraw from the audit engagement.

Besides identifying and disclosing all related-party transactions, especially those that are material, the auditor must make certain that a transaction actually occurred as indicated. It is possible that a company is manipulating its financial records by reporting a related-party transaction that did not actually happen. Because of a lack of independence between related parties, the Sarbanes-Oxley Act of 2002 prohibits related-party transactions that involve personal loans to any director or executive officer of a public company. This rule does permit banks and other financial institutions to make normal loans at market rates to their directors and officers.

In searching for related-party transactions, the auditor obviously looks for the names of known officers, subsidiaries, major investors, and the like on documentation supporting various entity transactions. In addition, the auditor looks quite carefully at any transactions occurring near the end of the year that had a significant impact on the financial statements. The auditor also pays special attention to transactions that do not conform to the standards, conditions, or terms of traditional transactions, such as loans without a repayment schedule, sale prices set at an amount different than fair value, low-interest rate loans, and any other suspect and suspicious transactions.

Estimates, including those of a significant size, are found quite commonly throughout a set of financial statements. Thus, substantiation of such estimates is extremely important. The auditor's work is made more complicated by the need for this substantiation because there is generally less objective evidence in existence for accounting estimates than for other types of accounting transactions.

For estimates, the auditor seeks to evaluate management's system or method for identifying and making specific estimates. In addition, the auditor tries to evaluate the reasonableness of each significant (i.e., material) estimate. 1. The auditor must evaluate the estimation system or method. 2. The auditor must then evaluate the reasonableness of the estimate.

An auditor can evaluate the reasonableness of the estimate in the following ways: 1. Examine the methodology and accuracy of similar estimates that may have been made in the past. 2. Review subsequent events for additional information and support for the reasonableness of the estimate. 3. Hire an outside specialist to evaluate the estimate if this appears to be appropriate.

Discovery of the following items might cause the auditor to be concerned about going-concern issues with the reporting entity: 1. Recurring losses and negative cash flows from operations. 2. Negative working capital. 3. Need for troubled restructuring of debt. 4. Default on existing debt. 5. Major dollar amount lawsuits or pending lawsuits. 6. Declared but unpaid stockholder dividends. 7. Loss of key customers and/or vendors.

If signals are found that indicate that there is substantial doubt as to the company's ability to remain a going-concern for at least one year from the balance sheet date, the auditor would request management's plans as to how this doubt will be resolved or at least lessened to improve the likelihood that the company can remain in business for at least the next 12-month time period.

If the auditor is satisfied that management's plans will remove the element of substantial doubt about the company's existence as a going-concern, neither the financial statements or the audit report are impacted.

If the auditor continues to believe that there is substantial doubt about the company's ability to continue as a going-concern for a minimum of one year from the balance sheet date after evaluating management's plans to remedy the situation, an explanatory paragraph as to the auditor's doubt is added after the opinion paragraph in the audit report. Although the remainder of the audit report is left unchanged, the extra paragraph is designed to alert readers to the going-concern matter. This paragraph often directs readers to a footnote in the financial statements that discusses the problem and management's proposed plans to remedy the situation. As an alternative, a disclaimer of opinion audit report might be appropriate.

The audit documentation that is retained by the auditor should indicate the following: 1. The nature, extent, and timing of all the audit procedures that were performed. 2. The sufficient appropriate evidence that was obtained from these procedures. 3. Which members of the audit engagement team were responsible for the various audit procedures, including the date the work was performed, who did the work, the date the work was reviewed, and who reviewed the work. The documentation should be kept at least long enough to meet the needs of the firm's practice and to satisfy all legal and professional requirements. The Sarbanes-Oxley Act of 2002 requires registered audit firms to maintain audit documentation for at least seven years. Under GAAS, non-public company auditors are required to maintain client documentation for no less than five years.

The nature and extent of audit documentation varies significantly from account to account and is based on various factors, including the following: 1. The risk of material misstatement associated with the account balance or class of transactions being examined. 2. The extent of the auditor's judgement that was exercised and the auditor's conclusions that were reached concerning each segment of the audit under consideration, which should be plainly stated. 3. The nature of the audit procedures performed, as well as their significance to the assertion being tested. 4. The nature and extent of any exceptions that were uncovered.

The letter of representation should be signed by the chief executive officer, the chief financial officer, and any other party with sufficient knowledge of the entities financial statements.

The following are some preliminary steps taken by an auditor when first approached about an audit engagement: 1. Talk with the entity and identify why an audit is needed, the identity of any previous auditors, all appropriate company history, and information on the entity's financing, ownership, and future business plans. Establish an understanding with the entity about the nature of the work to be performed, which should be documented. 2. Tour the facility and look at the entity's financial records, tax returns, and accounting information systems. 3. Discuss the proposed engagement with the entity's audit committee. 4. Seek permission to talk with the predecessor auditor: ask the predecessor about management integrity and any problems that were experienced with the entity. 5. Evaluate professional knowledge of the industry, independence, the management's integrity, the quality of the financial records, and any identified possible problems.

The letter of representation should be signed as of the date sufficient appropriate audit evidence has been obtained by the auditor. This is normally the last day of the auditor's field work. Thus, the letter of representation and the audit report will have the same date in most cases. However, under certain circumstances, the letter of representation can be signed after the last day of field work. It is never signed before that date.

An auditor is not relieved of any responsibility with the receipt of management's letter of representation. The letter of representation is a required procedure in gathering audit evidence.

The following are some of the steps an auditor takes after an audit engagement has been accepted: 1. Visit predecessor auditor for a second time to review audit documentation from previous audit(s). 2. Make a preliminary assessment of the quantitative size of a material misstatement. 3. For each group of accounts and for each management assertion, set an acceptable level of audit risk. 4. Assess the inherent risk of a material misstatement occurring within the accounting information system. 5. Assess control risk, which is the risk of a material misstatement not being detected in a timely basis by the entity's internal controls. 6. Plan for securing sufficient appropriate evidence through substantive testing to reduce detection risk, hereby reducing planned audit risk to an acceptable level.

The audit plan includes a schedule of the various audit procedures that will be performed in an audit, including the substantive tests that are to be made. An audit plan is necessary so that the auditor can adequately plan and then conduct the audit in such as fashion as to accumulate sufficient appropriate evidence to support the assertions being made by management and render the audit opinion. The first Standards of Field Work requires adequate planning. An audit plan also helps to keep audit costs reasonable and minimizes possible client misunderstandings. An audit plan consists of too many steps to reserve these procedures to memory. The audit plan development may begin on acceptance of the audit engagement, but earnest development begins after an assessment has been made of the audit engagement's inherent risk and control risk. The auditor does not know how much substantive testing is needed until these two assessments have been made. The audit plan is continuously updated in response to new or revised information acquired by the auditor. In reality, the plan is not finalized until the engagement has been completed.

In a representation letter, the client's management documents certain important points about its responsibility regarding the audit and its financial statements: 1. Acknowledges its responsibility for the financial statements. 2. States its belief that the statements are presented fairly according to U.S. generally accepted accounting principles (GAAP). 3. States its responsibility for correcting any material misstatements. 4. Indicates its responsibility for the design and implementation of programs and controls to prevent and detect fraud. 5. Documents certain representations made to the auditor during the audit engagement.

The audit committee is responsible for hiring (and firing) the external auditor, a responsibility which emphasizes the separation of the auditor from the entity's management. The audit committee should be available to the external auditor for discussion when any transaction, event, or decision occurs that has a significant impact on the financial statements. In addition, the audit committee normally oversees the work of the internal audit staff within the company.

Analytical procedures are required to be performed in the planning stage of an audit to assess the risk of material misstatement. Any account or class of transactions that differs from the auditor's expectations presents a higher degree of risk. Analytical procedures are also required in the concluding stage of the audit to continue the accumulation of audit evidence to support the financial statements taken as a whole and evidence related to presentation and disclosure-related objectives. These final analytical procedures make certain that nothing has changed significantly without the auditor's notice. Analytical procedures can also be carried out as substantive tests (but are not required) during the audit field work process to reduce detection risk.

If the auditor discovers the possibility of a misstatement, the auditor should first evaluate whether or not it could be a material misstatement. If it is not a material misstatement, the auditor should inform the client of the information that has been discovered. There is no further responsibility for the auditor to investigate this matter because an audit is normally only designed to react to material misstatements. However, if the potential misstatement appears to be material, the auditor should seek additional evidence to establish whether a material misstatement does, indeed, exist and the effect that this misstatement may have on the financial statements. Uncorrected misstatements, though immaterial individually, may be material in the aggregate, so the auditor may have to further evaluate and consider their impact on the financial statements. The auditor accumulates information about uncorrected misstatements as the audit progresses so as to have evidence of all misstatements that have been discovered during the audit field work.

If a material misstatement is discovered, the auditor should ask the client's management to take remedial action. The audit committee is also informed of this finding, as the misstatement will likely have a significant effect on the financial statements. If the problem is not resolved, the auditor should talk with the audit committee. If an adjustment is still not made, the auditor will render either a qualified opinion or an adverse opinion. If the management does remedy the misstatement, an unqualified opinion may be appropriate if all other portions of the audit findings are acceptable.

If related-party transactions have occurred, the nature of the relationships and terms of the transactions should be disclosed. Both SFAS 57 and AU 334.07 require that all related parties be identified. The audit planning process should include related-party identification. This process should continue into the actual audit process. The audit team should be kept aware and updated of all related parties and known and/or discovered related-party transactions.

Under normal conditions, an auditor has no further responsibility once an audit opinion has been rendered. However, if information about the financial statements or the audit come to the auditor's attention after the audit report has been issued, the auditor must determine whether the original opinion can still be supported. If the validity of the opinion is in question, the auditor must investigate this matter further.

A company can state that a related-party transaction was made on the same terms as a similar transaction would have been made with an unrelated party, but only if that statement can be substantiated. It may be impossible for the auditor to verify that claim. If this is the case, a qualified opinion due to scope limitation may result.

For all significant contracts or agreements that are examined by the auditor, either abstracts of the contracts or agreements must be written by the auditor or a copy of these documents must be kept within the audit documentation. For documents such as the sales invoices that were inspected, some identification of them must be included in the documentation. For example, specific document numbers should be listed or a specific criterion for examination could be explained in the documentation (e.g., "all sales invoices for over $2,000 were examined").

Conditions that an auditor might find in the entity's accounting information system that would raise the possibility of fraud include the following: 1. Transactions that are not recorded in a timely or complete manner. 2. Unsupported or unauthorized account balances or transactions. 3. Last-minute adjustments in the financial records that significantly affect the financial statements. 4. Evidence of certain employees' access to various portions of the accounting information system that is inconsistent with their duties. 5. Internal control, in general, is quite weak.

The auditor's expectations for certain financial results and performance comparisons can be derived from the client's historical financial information, oftentimes using trend analysis, from the client's budgets and forecasts, competitor information, industry averages, and client internal relationships (both financial and nonfinancial). An example of an internal relationship would be a client increasing the cubic footage of store space by 50% and the auditor anticipating that heating costs would rise by a comparable rate or amount.

When risk of fraud is suspected, the following types of auditor testing might be appropriate: 1. Surprise inspection of physical assets. 2. Asset counts and inspections at year end or close to year-end. 3. Oral confirmation of certain large balances that have been previously confirmed only in writing. 3. Detailed review of large transactions. 4. Interviews with employees in high risk areas. 5. Analytical procedures and substantive testing of vulnerable assets such as cash, marketable securities, and accounts receivable.

Representations made by management would include the following: 1. Management responsibility for the financial statements. 2. That all records, data, and minutes have been made available to the auditor. 3. That all material transactions have been properly recorded. 4. That no fraud has occurred involving management with a significant role in internal control. 5. That no fraud has occurred that would have a material impact on the financial statements. 6. That there is no knowledge of any allegations of fraud by any employees or third parties. 7. That proper disclosure has been made of all related-party transactions, guarantees, contingencies, litigation issues, and similar items.

The successor auditor talks with the predecessor auditor at least twice. First, the successor talks to the predecessor after the engagement has been offered, but before it is accepted. Second, the successor talks to the predecessor after the audit engagement has been accepted. If the reporting entity will not give permission for these discussions, the successor auditor will usually not accept the engagement. If the engagement has been accepted, this situation would probably result in a qualified opinion audit report due to the scope limitation.

In talking with the predecessor auditor before accepting an audit engagement, the potential successor auditor is seeking information, such as the following: 1. Information about the integrity of the company's management. 2. Possible predecessor disagreements with management on accounting or auditing issues. 3. Possible predecessor communications with the audit committee regarding fraud, illegal acts, or internal control issues. 4. The (suspected) reason for the change in auditors.

After accepting an audit engagement, the successor auditor would like to review the audit documentation of the predecessor auditor concerning the client's previous audit(s). The successor is looking to substantiate the following: 1. The various accounting methods that the client has used in the past. 2. The current reporting period opening balances of the balance sheet accounts. 3. Information on previous audit timing, audit difficulties and/or complexities, and any unresolved issues.

The following information describes how an auditor evaluates the credibility of the auditor's evidence sources and ultimately, his expectations: 1. Expectations derived from several information sources are more credible than those derived from one source. 2. Expectations derived from outside of the reporting company are more credible than those expectations derived from inside the reporting company. 3. Expectations derived from an independent source within the company are more credible than those expectations derived from a source that is not independent. 4. Expectations derived from audited data are more credible than those expectations derived from data that has not been audited.

Having an attitude of professional skepticism means that the auditor should not accept client explanations on face value, but should be alert for any clues or suggestions that could indicate the possibility of a material misstatement. Professional skepticism is defined as a questioning mind that critically assesses the audit evidence that is discovered and accumulated.

In the subsequent period, the auditor is interested in the following: 1. Transactions and events that provide evidence about a balance that appears on the financial statements (e.g., selling inventory documents that it existed on the balance sheet date and could be sold, while settlement of a lawsuit at a particular sum can confirm a reported liability amount). 2. Transactions that are of such magnitude or of such importance that disclosure is required.

The understanding with a client about an audit engagement should include the following four areas: 1. Objective of the work. 2. Management's responsibilities (i.e., for the financial statements, internal control, compliance with laws, a representation letter, and making the appropriate records available). 3. Auditor's responsibilities (i.e., following generally accepted auditing standards and discussing any significant deficiencies with the audit committee). 4. Limitations of the audit (i.e., reasonable assurance, not absolute assurance, is being rendered).

In many audits, judgements must be made that are beyond the expertise of the auditor. In these situations, the hiring of a specialist is recommended. Such cases could possibly include the following: 1. Determination of the percentage that has been completed for a long-term construction contract. 2. Determination of the value of specialized items, such as artworks and complex financial instruments, including derivatives. The use of a specialist in an audit engagement is quite commonplace, but is generally not mentioned in the audit report. However, if the work of the specialist has led the auditor to give an opinion other than a standard unqualified opinion, then the name of the specialist can be mentioned.

The independent auditor should inform those charged with governance items that have a significant effect on the financial statements, such as accounting policy decisions, methods used to determine estimates, and proposed adjustments recommended by the auditors. The independent auditor should make certain that those charged with governance are aware of the following: 1. All questionable accounting policies and practices that are being used. 2. All of the alternative methods available for the accounting and disclosure of material financial information. 3. All material written and oral communications between the auditor and the management of the company, including any disagreements.

Analytical procedures are those financial comparisons and relationships that an auditor makes use of to assess whether account balances or other data appear reasonable, compared to the auditor's expectations. The auditor's expectations are usually stated as a range of amounts, and any client data that falls outside of this range is investigated more carefully because of the increased risk that is represents.

For each audit, the auditor should have a current file of audit documentation, which would include the audit program, all evidence gathered to substantiate the audit opinion, and an explanation of all significant problems encountered during the audit and their eventual resolution. The permanent file includes client data that normally remains unchanged for a period of years, such as general ledger account numbers, organization charts, copies of bond indentures, copies of lease agreements, and any other similar documentation.

The documentation of the mutual understanding between the auditor and the client concerning the audit engagement must be in the form of a written communication. This is typically accomplished with an engagement letter.

The audit committee should be comprised of members of a company's board of directors, and those individuals should be independent of the entity (i.e., not part of management).

Before engaging a specialist, the auditor must verify that person's reliability by inquiring about his education, certification, licensing, client list, and work references. The auditor must also inquire about the independence of the specialist as related to the client company. Independence is not absolutely required, but it does impact the amount of reliance that the auditor should place on the work performed by the specialist.

The auditor is responsible for making certain that the specialist understands what is needed from her by the auditor and the use that will be made of the specialist's work.

The auditor is seeking to substantiate the presentation, disclosure, and rights and obligations assertions. When assets have been pledged as security for a debt, that information needs to be disclosed, usually in the footnotes to the financial statements.

Examples of conflicting or missing evidence that could increase the auditor's assessment of the likelihood of fraud would include the following: 1. Missing documents. 2. Documents that appear to have been altered or changed. 3. Original documents are no longer available, so copies are the documents being used as originals. 4. Significant unexplained items appear in certain reconciliations. 5. Inconsistent or vague responses are given by management and/or other employees to explain unusual differences found during analytical procedures. 6. Inventory and/or other significant assets are missing.

Related-party transactions, if material, must be disclosed in the notes to the financial statements. Therefore, the auditor needs to find all of these transactions to verify the presentation and disclosure assertion. Related-party transactions are generally not arm's-length transactions and, therefore, increase the risk that the effect of these transactions are not valued at the same amounts as transactions with independent third parties. The Sarbanes-Oxley Act of 2002 specifically prohibits certain related-party transactions from occurring.

Situations that might occur between the client's management and the auditor that would increase the auditor's assessment of the likelihood of fraud include the following: 1. Restricting auditor access to records, facilities, employees, or customers. 2. Undue audit time pressure imposed by management. 3. Unusual delays by management in providing requested information. 4. Unwillingness by management to allow the auditor to apply computer-assisted audit techniques in the client's accounting information system. 5. Unwillingness on the part of management to revise reported figures or disclosures recommended by the auditor.

When asset fair value is an issue, the valuation method used by management needs to be examined by the independent auditor. The CPA should take the following steps: 1. Review the company's control to make sure that the valuation is appropriate. 2. Evaluate the expertise and experience of those individuals (either within the company and/or the outside specialist) who were involved in the fair value determination. 3. Learn of any significant assumptions that were used to arrive at fair value. 4. Review the process used by the client to monitor and assess asset impairment amounts and any changes in the underlying assumptions that were used in arriving at fair value.

When a valuation model is used in determining the fair value of an asset, the independent CPA should do the following: 1. Examine the valuation model for reasonableness and accuracy in computation. Consider alternative valuation models and determine whether these models are more appropriate. 2. Make sure management's assumptions are consistent with market information, the economic environment, and any past experience. The CPA should make certain that the anticipated cash flows are reasonable, based on reliable sources, and that there is proper justification for the discount rate that is being used. 3. Look for any subsequent events that might assist in evaluating management's valuation method or amount.