Auditing High-Risk Financial Statement Areas

What is the primary definition of non-compliance in a financial statement audit?

Non-compliance refers to acts of omission or commission, intentional or unintentional, by an entity that are contrary to prevailing laws and regulations.

How do management's and the auditor's responsibilities differ regarding compliance with laws and regulations?

Management is responsible for ensuring operations follow laws and reporting amounts accordingly, whereas the auditor is responsible for providing reasonable assurance that financial statements are free of material misstatements caused by non-compliance.

Is an auditor responsible for preventing or detecting all non-compliance within an entity?

No, the auditor is not responsible for preventing non-compliance nor expected to detect non-compliance with all laws, but only those having a direct, material effect on the financial statements.

What audit procedure is required for laws and regulations that have a direct effect on financial statements?

The auditor must obtain sufficient appropriate audit evidence regarding the relevant financial statement line items and disclosures governed by those laws.

What audit procedures are required for laws and regulations that have an indirect effect on financial statements?

The auditor is limited to inquiring of management and inspecting correspondence with relevant licensing or regulatory agencies.

What are three operational indicators that may suggest non-compliance with laws and regulations?

Indicators include regulatory investigations, unusual cash payments or cashier's check purchases, and transactions priced significantly above or below market value.

When an auditor identifies non-compliance, with whom should the matter first be discussed?

The auditor should discuss the matter with management at least one level above where the non-compliance occurred and, when appropriate, those charged with governance.

What course of action should an auditor consider if management refuses to provide additional information regarding suspected non-compliance?

The auditor should consult legal counsel and consider withdrawing from the audit engagement.

Under what condition may an auditor omit communicating identified non-compliance to those charged with governance?

Communication may be omitted only if the matter is clearly inconsequential.

In what specific situations may an auditor disclose client non-compliance to external outside parties?

External disclosure is permitted when responding to a court order or subpoena, answering a successor auditor's inquiries, or reporting under federal financial assistance requirements.

How does an uncorrected material misstatement due to non-compliance affect the audit report?

It results in either a qualified or an adverse audit opinion, depending on the materiality and pervasiveness of the misstatement.

How does an inability to obtain sufficient appropriate audit evidence regarding non-compliance affect the audit report?

It creates a scope limitation resulting in either a qualified opinion or a disclaimer of opinion.

Why do accounting estimates require special audit considerations?

Accounting estimates possess inherent estimation uncertainty and a lack of precision, making them susceptible to management bias.

What primary factor increases an accounting estimate's susceptibility to management bias?

The degree of subjectivity and complexity involved in making the estimate increases its susceptibility to management bias.

What are the three general approaches an auditor can use to test accounting estimates?

The auditor can evaluate events up to the audit report date, test management's estimation process, or develop an independent point estimate or range.

What three elements must the auditor evaluate when testing management's process for an accounting estimate?

The auditor must evaluate the estimation method used, the significant assumptions applied, and the underlying data utilized.

How does an auditor test the data used by management in creating an accounting estimate?

The auditor verifies that the data used is both relevant to the objective and reliable.

What indicates potential management bias in accounting estimates?

Bias is indicated by unjustified changes in estimation methods, selecting assumptions highly tailored to earnings goals, or picking extreme endpoints of an estimate range.

If management's recorded accounting estimate falls outside the auditor's reasonable range, how is the misstatement calculated?

The misstatement is measured as the difference between the recorded amount and the closest point of the auditor's reasonable estimate range.

What is the primary objective of an auditor regarding related party transactions?

The objective is to ensure that related party transactions are properly identified, accounted for, and adequately disclosed in accordance with the reporting framework.

What information is typically documented in a conflict of interest statement requested by auditors?

It details the identities of related parties, the nature of the relationships, and the specific terms of any transactions executed with them.

How does a compensating balance arrangement serve as an indicator of a related party transaction?

Entities rarely maintain required minimum balance deposits at a bank to benefit an unrelated third party without a related party arrangement.

Why is a loan guarantee considered a red flag for a related party transaction?

Unrelated parties do not typically assume financial liability to guarantee loans for independent third parties.

What initial step must an auditor take upon discovering previously unidentified or undisclosed related parties?

The auditor must promptly communicate the information to other members of the audit team and request that management identify all transactions with the newly discovered parties.

For issuer audits, what additional requirement must auditors perform regarding related party loan guarantees?

The auditor must evaluate whether the guaranteeing related party possesses the financial capability to support the guarantee.

What is the primary purpose of obtaining an attorney inquiry letter during an audit?

The letter provides corroborative audit evidence regarding management's evaluations of pending litigation, claims, and assessments.

What is the impact on the audit opinion if management refuses to permit communication with its external legal counsel?

The refusal constitutes a severe scope limitation requiring a disclaimer of opinion or withdrawal from the audit engagement.

How does an attorney's refusal to respond to a lawyer inquiry letter affect the auditor's report?

The refusal represents a scope limitation that results in a qualified opinion or a disclaimer of opinion.

Why does an auditor NOT ask legal counsel to evaluate the adequacy of financial statement disclosures?

Evaluating financial reporting framework disclosures is the auditor's responsibility, not legal counsel's expertise.

Under GAAP, what accounting treatment is required for a litigation loss that is probable and reasonably estimable?

The entity must accrue the estimated loss amount on the financial statements and disclose the details in the footnotes.

Under GAAP, how is a litigation loss treated if it is probable but cannot be reasonably estimated?

The loss cannot be accrued on the balance sheet, but it must be fully disclosed in the footnote disclosures.

Under GAAP, what accounting action is required for a loss contingency deemed reasonably possible?

The loss contingency requires footnote disclosure only and is not accrued.

Under GAAP, how should a loss contingency be handled if the probability of occurrence is remote?

Remote loss contingencies generally require no financial statement accrual or footnote disclosure.

If a loss contingency range is estimated between $100,000 and $400,000 with no amount being a better estimate, what amount must be accrued under GAAP?

The entity must accrue the minimum amount of $100,000 and disclose the potential for additional loss in the notes.

What period of time defines a 'reasonable period of time' for evaluating going concern under FASB?

It is one year after the date that the financial statements are issued or available to be issued.

How does GASB define a 'reasonable period of time' when evaluating going concern for governmental entities?

It is defined as one year beyond the balance sheet date.

What does the mnemonic FINE stand for regarding indicators of substantial doubt about going concern?

It stands for Financial difficulties, Internal matters, Negative trends, and External matters.

What are two examples of 'Financial difficulties' that indicate substantial doubt about going concern?

Examples include loan defaults, dividend arrears, and denial of trade credit by vendors.

What are two examples of 'External matters' that can create substantial doubt regarding going concern?

Examples include catastrophic uninsured natural disasters and catastrophic pending legal actions.

To effectively mitigate substantial doubt, what primary financial effect must management's plans achieve?

Management's plans must effectively increase cash inflows or decrease cash outflows in a practical manner.

Why is the planned sale of assets categorized as a valid mitigating factor for going concern issues?

Selling assets generates immediate cash inflows needed to sustain ongoing operations and satisfy short-term debts.

In a non-issuer audit, how is the report modified when substantial doubt about going concern remains after evaluating management's plans?

The auditor must add a separate section titled 'Substantial Doubt About the Entity's Ability to Continue as a Going Concern'.

What two explicit terms must be included in the non-issuer auditor's going concern section when substantial doubt remains?

The section must include the terms 'substantial doubt' and 'going concern'.

In an issuer audit, how does an auditor report remaining substantial doubt about going concern under PCAOB standards?

The auditor adds an explanatory paragraph to the standard unqualified audit report.

If an entity's going concern disclosures are inadequate under GAAP, what audit opinion should be issued?

The auditor must issue a qualified or an adverse opinion due to a departure from GAAP.

What audit opinion is required if an entity facing imminent liquidation prepares financial statements using the going concern basis?

The auditor must issue an adverse opinion because the financial statements are prepared using an inappropriate accounting basis.

If substantial doubt about going concern is alleviated by management's plans in a non-issuer audit, is a report modification required?

No modification is required, though the auditor may voluntarily choose to include an emphasis-of-matter paragraph.

What happens to the going concern emphasis paragraph in subsequent audit years if the substantial doubt is completely removed?

The going concern paragraph or section is omitted and does not need to be repeated in subsequent audit reports.