Exam 1 - ACC 553

What is audit risk?

The risk that the auditor will issue an unqualified opinion on materially misstated financial statements.

What are the components of the Audit Risk Model?

Inherent Risk, Control Risk, and Detection Risk.

What is the formula for Audit Risk?

AR = RMM x DR, where RMM = IR x CR.

What does RMM stand for in the Audit Risk Model?

Risk of Material Misstatement, which is the combination of Inherent Risk (IR) and Control Risk (CR).

What is the relationship between Inherent Risk and Control Risk?

There is an inverse relationship between Detection Risk and both Inherent Risk and Control Risk.

What should be done if achieved risk is greater than planned risk?

The auditor needs to perform additional work.

What is the first step in the Audit Risk Model at the assertion level?

Set a planned level of audit risk.

What is the purpose of the Fraud Risk Assessment Process?

To discuss and assess the risks of material misstatement due to fraud.

What are some steps in the Fraud Risk Assessment Process?

Brainstorming sessions among audit members, inquiries of management, identification of fraud risk factors, and understanding the entity’s closing process.

What factors should be considered when assessing fraud risk?

Unusual or unexpected relationships identified during analytical procedures.

What is the overall materiality determined for EarthWear Clothiers' income before taxes of $36 million?

$1,800,000 (5% of $36 million)

How is tolerable misstatement calculated in this example?

Tolerable misstatement is calculated as 50% of overall materiality, resulting in $900,000.

What should auditors consider when determining overall materiality aside from quantitative factors?

Auditors should consider qualitative factors, such as close to violating a covenant in a loan agreement.

What is the total misstatement identified during the audit for EarthWear Clothiers?

The total misstatement is less than the overall materiality and no individual misstatement exceeds the tolerable misstatement.

What happens if the aggregated misstatements exceed overall materiality?

The entity would need to adjust the financial statements or the auditor would need to issue a qualified or adverse opinion.

What demonstrates that the account balances for EarthWear Clothiers are fairly stated?

The conclusion states that based on the analysis, the account balances are fairly stated in accordance with GAAP.

What constitutes Step 3 in applying materiality in auditing?

Step 3 is to evaluate audit findings, comparing misstatements to tolerable misstatement allocated to each account.

What is the significance of statistical sampling in determining misstatements?

Statistical sampling indicates the misstatement of inventory and helps in evaluating fair presentation of accounts.

In the example, what should auditors document regarding the aggregated misstatements?

Auditors should document their conclusion on whether the aggregated misstatements cause the financial statements to be materially misstated.

What is the proposed adjusting entry related to payroll expense for EarthWear Clothiers?

To accrue payroll through 12/31 and recognize 2021 bonuses, with entries showing an impact on assets, liabilities, and expenses.

What is a dual purpose test in auditing?

A test of transactions that assesses both the effectiveness of controls and detects monetary errors.

What is the purpose of audit data analytics?

To discover and analyze patterns, anomalies, and other information using analysis, modeling, and visualization.

Define materiality in the context of auditing.

The overall materiality is the maximum amount that misstatements could exist and still not affect users' decisions.

What is tolerable misstatement/performance materiality?

The amount of overall materiality used to establish the scope for audit procedures for individual account balances and disclosures.

What is the 'Rule of Thumb' percentage for determining overall materiality based on income before taxes?

5% of income before taxes.

List two qualitative factors that affect the appropriate percentage for materiality.

Material misstatements in prior years and high risk of fraud.

What percentage range is commonly used to determine tolerable misstatements per account?

50% to 75% of overall materiality.

What factors might lead firms to use total combined tolerable misstatements greater than overall misstatements?

Not all accounts will be misstated by the full amount and accounts are audited simultaneously.

What conclusion can an auditor draw if misstatements are less than overall materiality?

The financial statements are fairly presented.

What should an auditor do if the client refuses to adjust the financial statements after material misstatements are identified?

The auditor should issue a qualified or adverse opinion because the financial statements are not fairly presented.

What is the role of the audit committee in financial reporting?

Responsible for the financial reporting and disclosure process.

Under what act are the requirements for the audit committee stated?

Section 301 of the Sarbanes Oxley Act.

What is required of each member of the audit committee?

Each member must be a member of the board of directors and independent of the company.

What must the audit committee preapprove?

All audit and non-audit services provided by the auditor.

What procedures must the audit committee establish regarding complaints?

Procedures for the receipt, retention, and treatment of complaints about accounting, internal control, and auditing.

What authority does the audit committee have in terms of external counsel?

The authority to engage independent counsel or other advisors as necessary.

What should the audit committee do before engaging the auditor?

Meet with the auditor to discuss responsibilities and significant accounting policies.

What are the types of audit procedures?

Risk assessment procedures, test of controls, and substantive procedures.

What do risk assessment procedures include?

Inquiries of management, preliminary analytical procedures, observation, and inspection.

What is the purpose of test of controls procedures?

To test the operating effectiveness of controls in preventing, detecting, and correcting material misstatements.

What are substantive procedures designed to detect?

Misstatements, particularly concerned with monetary misstatements.

What are substantive tests of transactions?

Tests that examine errors for fraud in individual transactions.

What is the focus of tests of details of account balances and disclosures?

Items contained in the ending financial statement account balances and disclosures.

What are substantive analytical procedures?

Evaluations through trends and ratios within a broader set of audit data analytics.

What are the main considerations for prospective client acceptance in the audit process?

Capabilities to perform the engagement, compliance with legal and ethical requirements, and integrity of the client.

What must a successor auditor obtain from a client before communicating with a prior auditor?

Permission from the client.

What inquiries might a successor auditor make to a prior auditor?

Management integrity, suspected fraud, disagreements with management, understanding of the change in auditors, and transactions with related parties.

What happens if a client refuses to allow communication with the prior auditor?

It raises automatic red flags regarding the integrity and motivation of management.

What is required for client continuance in public accounting firms?

Firms should regularly assess whether to continue relationships with current clients.

When does client continuance typically take place?

At or near the end of audit completion or when a significant event occurs.

What should be established to reduce risks of misinterpretation in an audit engagement?

An understanding of the terms of the engagement.

What should the terms of engagement include?

Objectives, management's responsibilities, auditor’s responsibilities, limitations, and any additional services.

Who can assist auditors in conducting an audit?

Internal auditors, but their assistance depends on competency and organizational policies.

What factors determine the use of internal auditors in the audit process?

Level of competency, organizational status, and relevant supporting policies and procedures.

What approach should the internal audit function apply?

A systematic and disciplined approach to quality control.

What organization serves the public interest by strengthening the accounting profession internationally?

International Auditing and Assurance Standards Board (IAASB)

What does the International Standards on Auditing represent?

An auditing standard setter outside of the US.

What is the role of the International Accounting Standards Board?

It serves as an accounting standard setter outside of the US.

Which organization focuses on enhancing the development of strong international economies in the accounting profession?

International Auditing and Assurance Standards Board (IAASB)

What are the four types of auditors listed in Chapter 2?

External Auditors, Internal Auditors, Government Auditors, Fraud Auditors.

What characterizes external auditors?

They are independent and not employees of the company being audited.

What is the role of internal auditors?

They are employees of the company being audited.

What is a key responsibility of government auditors?

They are employed by federal, state, and local agencies.

What type of auditors are specifically trained to detect and investigate fraud?

Fraud Auditors.

Name one type of audit focused on compliance with laws and regulations.

Compliance audits.

What significant event in 2001 affected the auditing industry?

The Enron scandal involving auditor Arthur Anderson.

What legislation was passed in 2002 in response to the auditing crisis?

The Sarbanes-Oxley Public Company Accounting Reform and Investor Protection Act.

What does the Sarbanes-Oxley Act empower the PCAOB to do?

To oversee and inspect audit firms.

What major act was passed in 2010 regarding foreign audit firms?

The Dodd-Frank Wall Street Reform and Consumer Protection Act.

What is one of society's expectations from auditors?

To exercise due care in their work.

What does professional skepticism in auditing refer to?

A questioning mind and critical assessment of evidence.

Who is ultimately responsible for the fairness of the financial statements?

Management.

What is a primary component of corporate governance?

Oversight and supervision of managers on entity’s assets.

What is the role of the independent auditor in corporate governance?

To facilitate oversight and provide assurance of financial reporting.

List the five processes involved in business as mentioned in the notes.

Financing, purchasing, HR, inventory, revenue.

Why do auditors rely on concepts like materiality and audit risk when designing an audit?

To ensure cost-effectiveness and feasibility, as they cannot examine every transaction.

What is materiality in the context of an audit?

An amount that could be misstated without affecting a reasonable person’s judgment.

What happens if uncorrected misstatements are judged material?

The auditor asks clients to fix the big misstatements.

What is the relationship between sample size and materiality?

There is an inverse relationship between sample size and materiality.

What is audit risk?

The risk that the auditor mistakenly provides a clean opinion on financial statements that are materially misstated.

What are key descriptors of evidence in an audit?

Sufficient (quantity) and appropriate (quality) evidence.

What constitutes an unqualified or unmodified audit report?

It indicates that the audit is free of material misstatements.

What is the first step in the five-step process of Audit Data Analytics (ADA)?

Plan the ADA.

What does blockchain technology provide in the context of financial technologies?

Decentralized distributed digital ledgers that enhance operational efficiency, transaction transparency, and data reliability.

What is considered a material misstatement as per the rule of thumb?

More than 5% of income before tax.

What is the primary purpose of an audit?

To assure investors and other stakeholders that a company's financial information is honest and reliable.

Define information asymmetry.

A situation where the manager has more information about the true financial position than the owner.

What are agents and principals in the context of auditing?

Agents are managers supervising company assets, while principals are stockholders or owners.

How do audits reduce information risk?

By determining whether the manager's reports are credible and reducing the likelihood of false or misleading information.

What are financial statement assertions?

Implied claims made by management that are reflected in financial statements and guide auditors in gathering evidence.

What characterizes assurance services?

Independent professional services aimed at improving the quality or context of information for decision-makers.

What is the difference between assurance services and attest services?

Assurance services include a broader range of services, while attest services are specifically reports on subject matter or assertions by another party.

What specialized service involves evaluating another party's assertions against predetermined criteria?

Auditing.

What analogy is used to describe the role of an auditor?

An auditor is likened to a detective, gathering clues (evidence) and comparing it to the assertions made.

What is the outcome of regular financial reporting for lenders?

It may lead to reduced information risk and possibly lower interest rates.