Chapter 6 Review

Professional Skepticism 

An attitude of the auditor that includes a questioning mind that is alert to conditions that may indicate possible misstatement due to fraud or error and a critical assessment of audit evidence.

Professional Judgment 

Professional judgment is the auditor's use of appropriate judgment when making decisions during an audit. Professional skepticism is one component of professional judgment.

Financial statement cycles are

a way of organizing an audit by dividing the financial statements into smaller segments or components and keeping closely related types of transactions and account balances together.

Management assertions are

implied or expressed representations by management about classes of transactions, related account balances, and presentation and disclosures in the financial statements.

Existence or Occurrence

• Existence: The assets, liabilities, and equity amounts included in the financial statements actually exist.

• Occurrence: Recorded transactions actually occurred.

Example: Management is asserting that a recorded sale actually occurred and was not a fictitious transaction.

Completeness 

Management is asserting that all transactions, account balances, and required disclosures that should be included are included.

Example: Management is asserting that all sales that occurred during the year were recorded in the accounting records.

Valuation or Allocation 

Management is asserting that amounts included in the financial statements are recorded at the appropriate amounts and that amounts are properly allocated.

Example: Management is asserting that inventory is recorded at an appropriate value.

Rights & Obligations 

Management is asserting that the company owns or controls its assets and that its liabilities are actually obligations of the company.

Example: Management is asserting that equipment recorded as an asset is owned by the company.

Presentation & Disclosure 

Management is asserting that financial statement amounts are properly presented, classified, aggregated or disaggregated, and that relevant and required disclosures are included and understandable.

Example: Management is asserting that required information about a loan is properly presented and disclosed in the financial statements and notes.

Cutoff 

Cutoff means that transactions near the balance sheet date are recorded in the proper accounting period.

Example: A sale made on December 31 should be recorded in the appropriate year rather than being recorded as a January sale.

The objective of a financial statement audit is to

obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to error or fraud.

Additionally, what does an auditor’s opinion cover?

The auditor then expresses an opinion on whether the financial statements are:

1. Fairly presented

2. Free from material misstatement

3. Presented in accordance with the applicable financial reporting framework, such as GAAP

Audit objective →

reasonable assurance → auditor's opinion on whether the financial statements are fairly presented, materially free from error or fraud, and in accordance with GAAP.

What is management’s responsibility

1. Adopting sound accounting principles

2. Maintaining adequate internal controls

3. Making fair representations in the financial statements

4. Certifying the quarterly and annual financial statements

Management is responsible for the accounting records and financial statements and takes full ownership of what is presented.

What is the auditor’s responsibility in a financial statement audit? 

The auditor is responsible for obtaining reasonable assurance that the financial statements as a whole are free from material misstatement due to error or fraud.

The auditor then:

• Expresses an opinion on the financial statements.

• Reports and communicates as required by auditing standards.

• Detects material errors.

• Detects material fraud.

• Considers relevant laws and regulations.

Key difference:

Management prepares and takes responsibility for the financial statements;

the auditor examines them and provides an independent opinion.

What is the difference between fraud and an error?

• Error = no intent

• Fraud = intent

Error

An error is an unintentional misstatement of the financial statements.

• Example: A manager accidentally records a $10,000 sale as $100,000 because of a data-entry mistake.

• If the amount is significant enough to affect users' decisions, it would be a material error. Auditors are concerned with detecting material errors.

Fraud is an

intentional misstatement of the financial statements.

• Example: A manager intentionally records a $100,000 sale that never occurred in order to inflate the company's earnings and receive a larger bonus.

• This would be material fraud if the misstatement is significant enough to affect users' decisions.

What is the relationship between Professional skepticism and professional judgment in an audit?

Professional skepticism is one component of professional judgment.

Professional skepticism requires the auditor to have:

• A questioning mind

• A critical assessment of audit evidence

• An awareness that evidence may contain errors or indications of fraud

Professional judgment allows the auditor to use that information and make

appropriate decisions during the audit.

Why is it important that an auditor have both professional judgment and professional skepticism? 

It is important to have both because the auditor needs to question and critically evaluate evidence while also using professional judgment to determine what conclusions and audit procedures are appropriate.

Why do auditors break an audit into financial statement cycles? Give an example of a financial statement cycle. 

Auditors divide financial statements into smaller segments or components to make the audit more manageable and to help assign tasks to different members of the audit team.

Closely related transactions and account balances are grouped together.

• Example: The sales and collection cycle can include transactions and balances related to sales and accounts receivable.

• The cycle approach allows auditors to examine each cycle separately while still considering the relationships between cycles.

Define the 5 management assertions.

E → C → V → R → P

• Existence/Occurrence = Does it exist/happen?

• Completeness = Is everything included?

• Valuation/Allocation = Is it valued correctly?

• Rights/Obligations = Does it belong to the company?

• Presentation/Disclosure = Is it shown and explained properly?

Existence & Occurrence

Definition and example

Assets and balances exist, and recorded transactions actually occurred.

• Management asserts that a recorded sale actually happened.

Completeness

Definition and example

All transactions, balances, and required disclosures that should be included are included.

• Management asserts that all sales made during the year were recorded.

Valuation or Allocation

Definition and example

Amounts are recorded at appropriate values and properly allocated.

• Management asserts that inventory is recorded at an appropriate value.

Rights & Obligations

Definition and example

The company owns or controls its assets and its liabilities are its obligations.

• Management asserts that equipment listed as an asset belongs to the company.

Presentation & Disclosure

Definition and example

Amounts and information are properly classified, presented, and disclosed.

• Management asserts that required loan information is properly disclosed in the financial statements.

What is the relationship between audit objectives and management assertions?

Management makes assertions about the financial statements. The auditor uses those assertions to develop audit objectives and then performs audit procedures to test whether the objectives have been met.

In other words:

• Management assertions → Audit objectives → Audit procedures → Audit evidence → Auditor's conclusion

• Big picture to remember: Management makes the assertions; the auditor turns those assertions into objectives and tests the objectives to obtain evidence supporting the audit opinion.

The five PCAOB categories of management assertions are:

1. Existence & Occurrence

2. Completeness

3. Valuation or Allocation

4. Rights & Obligations

5. Presentation & Disclosure

Your notes also identify the seven transaction-related audit objectives:

1. Occurrence

2. Completeness

3. Accuracy

4. Posting and Summarization

5. Classification

6. Timing

7. Presentation

And the nine balance-related audit objectives:

1. Existence

2. Completeness

3. Accuracy

4. Cutoff

5. Detail Tie-In

6. Realizable Value

7. Classification

8. Rights and Obligations

9. Presentation

The major reason an independent auditor gathers audit evidence is to

form an opinion on the financial statements.

Which of the following best describes the reason why an independent auditor reports on financial statements?

Different interests may exist between the company preparing the statements and the persons using the statements.

Because of the risk of material misstatement, an audit should be planned and performed with an attitude of

professional skepticism.

An independent auditor has the responsibility to design the audit to provide reasonable assurance of detecting errors and fraud that might have a material effect on the financial statements. Which of the following, if material, is a fraud as defined in auditing standards?

Misappropriation of an asset or groups of assets

What assurance does the auditor provide that errors and fraud that are material to the financial statements will be detected?

Errors	Fraud
(1) Limited	Negative
(2) Reasonable	Reasonable
(3) Limited	Limited
(4) Reasonable	Limited

Reasonable Reasonable

Which of the following statements describes why a properly designed and executed audit may not detect a material misstatement in the financial statements resulting from fraud?

Audit procedures that are effective for detecting unintentional misstatements may be ineffective for an intentional misstatement that is concealed through collusion.

An auditor reviews aged accounts receivable to assess likelihood of collection to support management’s assertion about account balances of

accuracy, valuation, and allocation.

An auditor will most likely review an entity’s periodic accounting for the numerical sequence of shipping documents to ensure all documents are included to support management’s assertion about classes of transactions of

completeness.

In the audit of accounts payable, an auditor’s procedures will most likely focus primarily on management’s assertion about account balances of

completeness.

The auditor’s responsibility regarding material misstatements caused by fraud is

the same as the auditor’s responsibility regarding material misstatements caused by error.

Which of the following would not have a direct impact in determining the sufficiency of evidence gathered during an audit?

The cost-benefit relationship of obtaining the audit evidence

When determining the auditor’s or management’s responsibility for compliance with laws and regulations during an audit, which of the following statements below would be incorrect?

The auditor is expected to detect the client’s noncompliance with all laws and regulations affecting transaction cycles under review during the audit itself.

Auditors provide “reasonable assurance” that the financial statements are “fairly stated, in all material respects.” Questions are often raised as to the responsibility of the auditor to detect material misstatements, including misappropriation of assets and fraudulent financial reporting.

Discuss the concept of “reasonable assurance” and the degree of confidence that financial statement users should have in the financial statements.

“Reasonable assurance” is a key idea in auditing. It refers to the level of certainty the auditor achieves by the end of the audit that the financial statements are free of material misstatement—whether from fraud or error. Auditing standards define it as a high, but not absolute, level of assurance.

This means:

• The auditor is not a guarantor or insurer of the financial statements’ correctness.

• An audit done in accordance with standards can still fail to detect a material misstatement, because:

  • Evidence is usually based on sampling, which always includes some risk.

  • Many accounts involve complex estimates and uncertainty; evidence is persuasive, not perfectly convincing.

  • Fraud, especially with collusion by management or others, can be extremely difficult to detect.

For financial statement users, “reasonable assurance” justifies a high degree of confidence that the statements are “fairly stated, in all material respects,” but it does not mean absolute certainty or zero risk of undetected fraud or error.

Auditors provide “reasonable assurance” that the financial statements are “fairly stated, in all material respects.” Questions are often raised as to the responsibility of the auditor to detect material misstatements, including misappropriation of assets and fraudulent financial reporting.

What are the responsibilities of the independent auditor in the audit of financial statements? Discuss fully, but in this part do not include fraud in the discussion.

The independent auditor’s main responsibilities are to:

• Obtain reasonable assurance that the financial statements are free from material misstatement.

• Express an opinion on whether the financial statements are fairly presented in all material respects according to the applicable framework, such as GAAP or IFRS.

• Follow auditing and ethical standards, maintain independence, and obtain sufficient appropriate evidence.

• Understand and evaluate internal controls relevant to financial reporting to help determine whether the financial statements are reliable and fairly presented.

In short: The auditor independently examines the financial statements and supporting evidence, evaluates internal controls, and provides an opinion with high, but not absolute, assurance that the statements are fairly presented.

Auditors provide “reasonable assurance” that the financial statements are “fairly stated, in all material respects.” Questions are often raised as to the responsibility of the auditor to detect material misstatements, including misappropriation of assets and fraudulent financial reporting.

What are the responsibilities of the independent auditor for the detection of fraud involving misappropriation of assets and fraudulent financial reporting? Discuss fully, including your assessment of whether the auditor’s responsibility for the detection of fraud is appropriate.

The independent auditor is responsible for obtaining reasonable assurance that the financial statements are free from material misstatement due to fraud or error. This includes both fraudulent financial reporting, where financial information is intentionally manipulated or omitted, and misappropriation of assets, where company assets are stolen or misused.

Auditors must assess fraud risk, maintain professional skepticism, and perform appropriate audit procedures to detect material misstatements caused by fraud. If fraud is suspected, the auditor should perform additional procedures, gather more evidence, and communicate the findings as required.

The auditor’s responsibility is appropriate because it requires auditors to actively look for material fraud while recognizing the practical limits of an audit. Fraud can be intentionally concealed, so an audit provides reasonable assurance rather than an absolute guarantee that all fraud will be detected.