Chapter 1: An Introduction to Assurance and Financial Statement Auditing

Based on Auditing & Assurance Services: A Systematic Approach Author: William Messier, Jr

(LO 1-1) What is the focus of auditing?

Learning the analytical and logical skills necessary to evaluate the relevance and reliability of financial information, as well as the adequacy of the systems and processes responsible for recording and summarizing that information

(LO 1-1) "Learning auditing essentially helps you understand how to ____________ so you can evaluate assertions (or claims) made by others.”

Gather and assess evidence

(LO 1-2) What is an audit?

A service that provides assurance to investors, creditors, or other stakeholders that a company is being honest about its financial information and that the information is reliable

(LO 1-2) “The demand for auditing can be understood as ____________”

The need for accountability when business owners hire others to manage their businesses

(LO 1-2) Public Company

A company that sells its stocks or bonds to the public, giving the public a valid interest in the proper use of the company’s resources

(LO 1-2) “Managers serve as ________ who fulfill a stewardship function by managing the corporation’s assets for the owners (who are sometimes referred to as _________).”

Agents; principals

(LO 1-2) Information Asymmetry

The concept that the manager generally has more information about the true financial position and results of operations of the entity than the absentee owner does

(LO 1-2) Because the goals the owner and manager may not coincide, there is a natural _____________

Conflict of Interest

(LO 1-2) How do owners typically prevent conflict of interest?

They set the managers’ contracts to include requirements to report regularly to owners on the quality of their work and on how well he or she has managed the owners’ assets

(LO 1-2) From what point does the demand for auditing arise?

The manager being in a position to manipulate the financial reports, which the absentee owner cannot directly observe

(LO 1-2) What is the auditor’s role?

To determine whether the reports prepared by the manager conform to the contract’s provisions

(LO 1-2) When the auditor carries out their role, what are the benefits?

• Credibility is added

• Information risk is reduced

(LO 1-2) Information Risk

The risk that information reported by a company’s management could be false or misleading

(LO 1-2) True or False: Reducing information risk benefits both the owner and the manager by making the manager’s reports more credible.

True

(LO 1-2) Auditing plays a valuable role in monitoring the ____________ between the entity and its stockholders, managers, employees, and debt holders.

Contractual Relationships

(LO 1-2) Assertions

Representations, explicit or otherwise, with respect to the recognition, measurement, presentation, and disclosure in the financial statements, which are inherent in management, representing that the financial statements are prepared in accordance with the applicable financial reporting framework

(LO 1-2) “Assertions are used by the auditor to __________”

Consider the different types of potential misstatements that may occur when identifying, assessing, and responding to the risks of material misstatement

(LO 1-2) True or False: Some assertions are more important than others because of their potential risk or cost.

True

(LO 1-2) What two things exist between managers of companies and potential investors?

Information Asymmetry and Conflicts of Interest

(LO 1-2) Examples of implicit assertions about cash by management

• Cash is really there (exists)

• The cash records are complete

• The cash amount is fairly and accurately recorded, and that no other parties have valid claims to the cash

(LO 1-2) Financial Statement Assertions

Management’s expressed or implied claims about information reflected in the financial statements

(LO 1-2) Why are assertions central to auditing?

They are the focus of the auditor’s evidence collection efforts

(LO 1-2) What is one of the main tasks of the auditor?

To collect sufficient appropriate evidence that management’s assertions regarding the financial statements are correct

(LO 1-2) What are the two aspects of information reflected in the financial statements?

• Transactions and events and related disclosures

• Account balances and related disclosures

(LO 1-2) What are the assertions about classes of transactions and events, and related disclosures?

• Occurrence

• Completeness

• Authorization

• Accuracy

• Cutoff

• Classification

• Presentation

(LO 1-2) What are the assertions about account balances, and related disclosures?

• Existence

• Rights and Obligations

• Completeness

• Accuracy, Valuation, and Allocation

• Classification

• Presentation

(LO 1-2) Occurrence

Transactions and events that have been recorded or disclosed have occurred, and such transactions and events pertain to the entity

(LO 1-2) Completeness (Assertions about classes of transactions and events)

All transactions and events that should been recorded have been recorded, and all related disclosures that should have been included in the financial statements have been included

(LO 1-2) Authorization

All transactions and events have been properly authorized

(LO 1-2) Cutoff

Transactions and events have been recorded in the correct accounting period

(LO 1-2) Classification (Assertions about classes of transactions and events)

Transactions and events have been recorded in the correct accounting period

(LO 1-2) Presentation (Assertions about classes of transactions and events)

Transactions and events are appropriately aggregated or disaggregated and clearly described, and related disclosures are relevant and understandable in the context of the requirements of the applicable financial reporting framework

(LO 1-2) Existence

Assets, liabilities, and equity interests exist

(LO 1-2) Rights and Obligations

The entity holds or controls the rights to assets, and liabilities are the obligations of the entity

(LO 1-2) Completeness (Assertions about account balances and related disclosures)

All assets, liabilities, and equity interests that should have been recorded, and all related disclosures that should have been included in the financial statements have been included

(LO 1-2) Classification (Assertions about account balances and related disclosures)

Assets, liabilities, and equity interests have been recorded in the proper accounts

(LO 1-2) Presentation (Assertions about account balances and related disclosures)

Assets, liabilities, and equity interest are appropriately aggregated or disaggregated and clearly described, and related disclosures are relevant and understandable in the context of the requirements of the applicable financial reporting framework

(LO 1-3) Assurance Services

Independent professional services intended to help decision makers by improving the quality or context of the information they use

(LO 1-3) Attest Services

A subset of assurance services that involve reporting on an assertion or other subject matter that is the responsibility of another party

(LO 1-3) True or False: Auditing is not a type of attest service

False

(LO 1-3) What is auditing?

A systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between those assertions and established criteria and communicating the results to interest users

(LO 1-3) “Auditors search for _______ relating to assertions made by another party, and they objectively evaluate the relevance and validity of the _________ they find in relation to those assertions.”

Audit evidence; evidence

(LO 1-3) What typically serves as the basis for evaluating management’s assertions in the context of a financial statement audit in the United States?

GAAP

(LO 1-4) The conceptual and procedural details of a financial statement build on what fundamental concepts?

• Materiality

• Audit Risk

• Evidence Relating to Management’s Financial Statement Assertions

(LO 1-4) Materiality

• The amount by which a set of financial statements could be misstated without affecting the judgment of a reasonable person

• The maximum amount by which the auditor believes the financial statements could be misstated and still not affect the decisions of users

(LO 1-4) What is one of the auditor’s first tasks in planning an audit, as it relates to materiality?

Make a judgment about how big a misstatement would have to be before it would significantly affect users’ judgments.

(LO 1-4) Why is the auditor’s materiality judgment important?

Helps determine how much work the auditor will need to do

(LO 1-4) Why is the concept of materiality important in general?

It isn’t practical or cost beneficial for auditors to try to find every single misstatement in a set of financial statements

(LO 1-4) The lower the level at which the auditor assesses materiality, the _______ the amount of evidence the auditor must gather.

Greater

(LO 1-4) What is a common rule of thumb for determining materiality?

Total misstatements of more than about 5% of pretax income would cause the financial statements to be materially misstated

(LO 1-4) True or False: There can be no guarantee that the auditor will uncover all material misstatements, hence they provide reasonable assurance that material misstatements will be detected

True

(LO 1-4) Audit Risk

The risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated

(LO 1-4) Reasonable Assurance

A term that implies some risk that a material misstatement could be present in the financial statements without the auditor detecting it, even when the auditor has exercised due care

(LO 1-4) How can the auditor control the level of audit risk?

The effectiveness and extent of the audit work conducted

(LO 1-4) Why can’t audit risk be driven to 0?

Cost constraints and the sheer impossibility of investigating every item reflected in an entity’s financial statements

(LO 1-4) What is a synonym for evidence regarding management’s assertions?

Audit Evidence

(LO 1-4) Audit Evidence

All of the information used by the auditor in arriving at the conclusions on which the audit opinion is based

(LO 1-4) What are some of the different forms of audit evidence?

• Oral or visual information

• Paper or electronic documents

• Originating from within the entity or outside parties

(LO 1-4) What is used as a framework to guide the collection of audit evidence?

Management’s Assertions

(LO 1-4) What does the auditor use to determine the nature, timing, and extent of evidence to be gathered?

Management’s Assertions and the Assessment of Materiality and Audit Risk

(LO 1-4) When will the auditor have reasonable assurance that the financial statements are fairly presented?

When they have obtained sufficient appropriate evidence that the management assertions can be relied upon for each significant account and disclosure

(LO 1-4) Sufficiency of Audit Evidence

The quantity of evidence the auditor obtains

(LO 1-4) Appropriateness of Audit Evidence

The quality of evidence (provides information that is both relevant and reliable)

(LO 1-4) Relevance

Whether the evidence relates to the specific management assertion being tested

(LO 1-4) Reliability

The diagnosticity of the evidence (can it be relied upon to signal the true state of the account balance or assertion being examined)

(LO 1-4) True or False: Sufficiency and appropriateness of audit evidence are interrelated in that they jointly affected the persuasiveness of audit evidence

True

(LO 1-4) True or False: The auditor often has the luxury of obtaining completely conclusive evidence about the true state of a particular management assertion

False

(LO 1-4) In most situations, the auditor is able to obtain only _______ evidence that the assertion is presented fairly

Persuasive

(LO 1-5) How does an auditor deal with the problem of not being able to examine every transaction and account?

They select a subset of transactions and accounts to examine

(LO 1-5) How can an auditor be aware of items that are more likely to contain misstatements?

Previous audits, understanding of the entity’s system of internal control, and knowledge of the client’s industry

(LO 1-5) What does the auditor do when they have no special knowledge about which particular transactions are items may be misstated?

They use random sampling procedures (laws of probability) that increase the likelihood of obtaining a sample that is representative of the population of transactions or account items and make inferences about potential misstatements from there

(LO 1-5) What type of relationship exists between sample size and materiality?

Indirect

(LO 1-5) What type of relationship exists between sample size and desired level of assurance?

Direct

(LO 1-5) If an auditor assesses a small materiality for an account, a _______ sample will be needed

Larger

(LO 1-5) If an auditor assesses a larger materiality for an account, a _______ sample will be needed

Smaller

(LO 1-5) What can eliminate the need for sampling?

Auditors’ increasing use of data analytics, allowing for the testing of entire populations, especially when the audit is entirely focused on electronic records and there’s access to specialized audit software

(LO 1-5) Examples of when sampling will continue to be used when gathering audit evidence

• Information is from outside parties

• Inventory

(LO 1-6) What is the end product of an auditor’s work?

An opinion indicating whether or not the client’s financial statements are free of material misstatement

(LO 1-6) What is the first thing an auditor must do to obtain the information needed to develop and support their opinion (end product)?

Obtain a thorough understanding of the client, its business and industry, its information system, the risks present, and how the client may or may not respond to those risks

(LO 1-6) Entities must design and implement _______

Controls

(LO 1-6) Why are internal controls implemented?

To ensure that the client’s information system appropriately captures and records individual transactions, which are then collected into ending account balances

(LO 1-6) True or False: It is the auditor’s job to express an opinion on whether the financial statements are presented fairly.

True

(LO 1-6) The auditor can design procedures to collect ________ information about the ending account balances that make up the financial statements.

Direct

(LO 1-6) If the auditor designs procedures to test whether the transactions were captured and handled properly, the auditor can obtain ________ information about whether the ending account balances are likely to be presented fairly.

Indirect

(LO 1-6) True or False: Evidence about internal controls are not a cost-effective form of audit evidence

False

(LO 1-6) What are the three different stages in a client’s accounting system that an auditor can collect evidence in to help determine whether the financial statements are presented fairly?

• The system of internal control put in place by the client

• The transactions that affect each account balance

• The ending account balances

(LO 1-6) What type of evidence is usually the highest-quality evidence, but also the costliest to obtain?

Evidence that relates directly to ending account balances

(LO 1-6) True or False: For cost-effectiveness reasons, an audit usually relies on evidence from all three stages in forming an audit opinion regarding the fairness of the financial statements

True

(LO 1-6) Major Phases of an Audit

• Client Acceptance/Continuance

• Preliminary Engagement Activities

• Plan the Audit

• Consider and Audit Internal Control

• Audit Business Processes and Related Accounts

• Complete the Audit

• Evaluate Results and Issue Audit Report

(LO 1-6) To minimize the likelihood that an auditor will be associated with clients who lack integrity or otherwise present too much risk, what do professional standards require auditors to do?

Establish policies and procedures for deciding whether to accept new audit clients and to retain current clients

(LO 1-6) True or False: For a prospective new client, the auditor is not required to confer with the predecessor auditor and frequently conduct background check on top management

False

(LO 1-6) What are the three general preliminary engagement activities?

• Determine the audit engagement team requirements

• Ensure the independence of the audit firm and the audit team

• Establish an understanding with the client regarding the services to be performed and the other terms of the engagement

(LO 1-6) The auditor’s understanding of ____________ helps in assessing the risk of material misstatement and in setting the scope of the audit

Understanding of the entity and its environment

(LO 1-6) During the preliminary engagement activities stage of the audit, what does the engagement partner or management do?

Forms an audit team composed of members who have the appropriate audit and industry experience, determines whether specialists are needed, and make sure that the audit firm and individual team members are free from prohibited relationships that might threaten the auditor’s objectivity

(LO 1-6) What must the audit team do in order to plan the auditor properly?

Determine materiality and make a preliminary assessment of the client’s business risks

(LO 1-6) What is the preliminary assessment of the client’s business risks used for?

To assess risk relating to the likelihood of material misstatement

(LO 1-6) Risk of Material Misstatement (RMM)

The risk that the financial statements are materially misstated prior to the audit

(LO 1-6) What is the outcome of the auditor’s planning process?

A detailed audit plan that sets forth the nature, timing, and extent of the audit procedures to be performed

(LO 1-6) True or False: Audit planning should take into account the auditor’s understanding of the entity’s system of internal control

True