417 Test #1

Auditing

a systematic process of objectively obtaining and evaluating evidence regarding assesrtions and events to ascertain the degree of correspondence between the assertions and established criteria and communicating the results to interested users.

Managers

Often calles agents

Owners

Often called principals

Information Asymmetry

The manager who runs the business day to day, generally has more information about the “true” financial position and results of operations of the entity than does the absentee owner.

Information Risk

The risk that information reported by a companys management could be false or misleading.

Assertions

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

Occurrence

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

Completeness

All transactions and events (disclosures) that should have been recorded (included in the financial statements) have been recorded (included)

Authorization

All transactions and events have been properly authorized

Accuracy

Amounts and other data relating to recorded transactions and events have been recorded appropriately, and related disclosures have been appropriately measured and described

Cutoff

Transactions and events have been recorded in the correct accounting period

Classification

Transactions and events have been recorded in the proper accounts

Presentation

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

Existence

Assets, liabilities, and equity interests exist

Rights and Obligations

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

Completeness

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

Accuracy, Valuation, and Allocation

Assets, liabilities, and equity interests have been included in the financial

statements at appropriate amounts, and any resulting valuation or allocation

adjustments have been appropriately recorded, and related disclosures have

been appropriately measured and described

Classification

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

Presentation

Assets, liabilities, and equity interests 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

Attest services

Are a subset of assurance services. Are assurance services that involve reporting on an assertion or otheer subject matter that is the responsibility of another party

Materiality

refers to the amount by which a set if financial statements could be misstated without affecting the judgement of a reasonable person

Misstatement

A departure from the applicable reporting framework (e.g., GAAP) that, if material, causes the financial statements to not be presented fairly. Misstatements may be classified as fraud (intentional), other illegal acts such as noncompliance with laws and regulations (intentional or unintentional), and errors (unintentional).

Audit Risk

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

Reasonable Assurance

We conducted our audits in

accordance with the standards of the

PCAOB. Those standards require that

we plan and perform the audit to

obtain reasonable assurance about

whether the financial statements

are free of material misstatement,

whether due to error or fraud”

Audit evidence

All the information used by the auditor in arriving at the conclusions on which the audit opinion is based. Audit evidence is information to which audit procedures have been applied and consists of information that corroborates or contradicts assertions in the financial statements.

Sufficient (Quantity) and appropriate (Quality)

Two key descriptors of audit evidence

Sufficiency and appropriateness

Interelated that they jointly affect the persuasivness of audit evidence.

Unqualified

The financial statements present fairly so the auditor does not

find it necessary to qualify his or her opinion

Qualified

The financial statements are presented fairly except for a non-

pervasive departure from GAAP identified by the auditor

Adverse

The financial statements do not present fairly

Disclaimer

A scope limitation is so pervasive that it limits the ability of the

auditor to conclude on the financial statements

Materiality, Audit Risk, and evidece

Three fundamental concepts that underlie financial statement auditing.

Independence

A state of objectivity in fact and in appearance, including the absence of any significant conflicts of interest. (Auditors must have this in relation to the company they audit)

Internal Auditing

An independent, objective assurance and consulting activity designed to add value and improve an organizations operations.

Assurance Services

The BROADEST category intended to help decision makers by improving information quality or context.

~ Risk advisory services

~ Website security

Attestation Services

performed when an independent practitioner, or CPA, is engaged to issue a report on subject matter that is the responsibility of another party.

~ Review of historical financial statements

~ Examination of financial forecast

~ Agreed upon procedures

Audit Services

Are a subgroup of both attest and assurance services, but not all attest or assurance services are an audit.

Positive Assurance on historical financial statements

~ Historical financial statements

~ Internal controls

Examination

Positive Assurance on information other than historical financial statements (f/s)

Reviews

Limited Assurance on either F/S or other information

Agreed-Upon Procedures

Confirms that the auditor completed a list of

procedures, but the report does not express an opinion or a conclusion on the

subject matter.

System and Organization Controls (SOC) Reports

Entities use outside

organizations to process a portion of accounting transactions. These reports

attest to internal control existence (SOC1) or effectiveness (SOC 2) of the

outside company (e.g. ADP for payroll).

Nonaudit services

~ Compilation (prep + report)

~ F/S Prep

~ Tax prep & planning

~ Advisory

External Auditors

~ Not employees of the entities they audit,

~ Conduct financial statement, compliance, operational, and

fraud audits for publicly traded and private companies,

partnerships, universities, government entities.

Internal Auditors

~ Employees of the organizations that they audit,

~ Conduct financial, internal control, compliance, operational,

and fraud audits within their organizations.

Government Auditors

~ Usually type of internal auditor.

~ Employed by federal, state, and local agencies.

Fraud Auditors

~ Employed by corporations, government agencies, public

accounting firms, and specialized consulting and investigative

services firms,

~ Specially trained in detecting, investigating, and deterring fraud

and white-collar crime.

Partner

~ Reach agreement with the auditee on the scope of the service to be provided.

• Ensure that the audit is properly planned and that the audit is conducted in accordance with

applicable auditing standards.

• Assemble an audit team that has the required skills and experience.

• Supervise the audit team and review the working papers.

• Conclude on the adequacy of audit evidence and sign the audit report~

Manager

• Ensure that the audit is properly planned, including scheduling of team members.

• Supervise the preparation of and approve the audit program.

• Review the working papers, financial statements, and audit report.

• Recommend key audit judgments to partner, oversee the work of seniors and staff.

• Deal with invoicing and ensure collection of payment for services.

• Inform partner about any auditing or accounting problems encountered.

Senior/In-charge

• Assist in the development of the audit plan.

• Prepare budgets.

• Assign tasks to associates and direct the day-to-day performance of the audit.

• Perform procedures, gather and evaluate audit evidence.

• Supervise and review the work of associates.

• Inform the manager about any auditing or accounting problems encountered.

Associate/Staff

• Perform audit procedures assigned to them by the senior.

• Prepare adequate and appropriate documentation of completed work.

• Inform the senior about any auditing or accounting problems encountered.

Growth of Nonaudit services

1990s-2000s

Enron and Worldcom Scandals

2000-2001

Sarbanes-Oxley Act Passed

2002

Creation of the Public Company Accounting Oversight Board (PCAO

B) to set and enforce auditing standards for public company audits

Strict independence rules

Integrated audits for larger public companies

Dodd-Frank Wall Street Reform

& Consumer Protection Act

Passed

2010

• Granted PCAOB authority to inspect foreign audit firms that practice

in the U.S.

• Exempted smaller public companies from the requirement to obtain

an audit of ICFR

Professional skepticism

an attitude that includes a questioning mind and a critical assessment of audit evidence.

Corporate Governance

• All the people, processes, and activities in place to help ensure proper stewardship over an

entity’s assets.

• Strong corporate governance ensures that those managing an entity properly utilize their

time, talents, and the entity’s resources in the best interest of absentee owners or

shareholders.

Objectives, Strategies, and Processes

• Management, with oversight from the board of directors, decides on objectives and strategies

designed to achieve those objectives.

• The organization then undertakes certain processes to implement its strategies

Five broad business processes

• Financing Process.

• Purchasing Process.

• Human Resource Management Process.

• Inventory Management Process.

• Revenue Process.

Enterprise Risk management

• identify and respond to possible threats to the achievement of objectives.

• Establish a system of internal controls over financial reporting

Accounting information system

• Measure the performance of the business.

• To assess whether objectives are being met.

• To comply with external reporting requirements.

Management

preparing and presenting financial statements in accordance

with the applicable financial reporting framework;

• designing, implementing, and maintaining internal control over

financial reporting; and

• providing auditors with information relevant to the financial

statements and internal controls.

Audit Committee

Provides oversight of the

reporting process and

other parties.

Responsible for the

hiring, firing and paying

of the external auditors

PCAOB

issuers (Auditing

Standards or AS) and SEC adopts.

ASB of AICPA

– private companies

(Statements on Auditing

Standards or SAS)

IAASB

– firms with international

operations (International

Standards on Auditing or ISA)

Ethics

a system or code of conduct

based on moral duties and obligations that

indicate how we should behave

Professionalism

the conduct, aims, or

qualities that characterize a profession or

professional person

AICPA’s Code of Professional

Conduct

establishes guidance for

acceptable conduct for CPAs

Principles

Rules of Conduct

Interpretations of the Rules

Engagement Capabilities

Must possess technical skills and specialized knowledge of the relevant

industry or subject matters.

• Experience with pertinent regulatory or financial reporting frameworks.

• Availability of sufficient personnel and qualified specialists (if required).

• Ability to complete the engagement within established reporting deadlines.

• How? Review financial information: Annual reports, 10-Ks, registration statements, reports to

regulators

Ethical & Legal Compliance

Must adhere strictly to legal requirements and relevant ethical codes,

including maintaining independence in accordance with the Code of Professional Conduct.

Client Integrity

Evaluate the reputation, character, and attitudes of principal owners, key

management, and those charged with governance.

• Identify any inappropriate limitations placed on the scope of work.

• Screen for any indications of involvement in illegal activities.

• How? Search news articles, lawsuits, and bankruptcy court filings that name the client, board

members, CEO, CFO, or other high-ranking executives

• How? With client permission, request client’s bankers, legal counsel, underwriters, analysts,

or other persons who do business with the entity to provide information about the client and

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its management

Changing predecessor auditors

Standards REQUIRE: The prospective (new) auditor must attempt to communicate with

the predecessor (old) auditor.

▪ The new auditor must secure approval from the audit client before

communicating with the predecessor.

▪ Then, the prospective auditor can ask the predecessor questions.

What should the auditor ask about

▪ Is there information about management integrity?

▪ Were there identified or suspected frauds or matters of noncompliance with laws

and regulations in the prior audits? Were these communicated to audit

committees, internal auditors, management (CEO, CFO)?

▪ Was there a disagreement with management about accounting policies, auditing

procedures, or other significant matters?

▪ If not disagreement, what was the reason for auditor change?

▪ If there is information about the company’s relationships or transactions with

related parties or other unusual transactions that the new auditor should be

aware of?

What is required for continuing client retention

Audit firms must periodically re-evaluate existing clients (typically after audit completion or significant

organizational events) to decide whether retention is appropriate. Key conflict areas evaluated include:

• Conflicts over accounting policies, estimates, or auditing procedures.

• Disputes or disagreements regarding audit fees.

• Excessive operational, financial, or reputational engagement risk.

Required preliminary engagement activities

1. Determine engagement team requirements

2. Check audit team and firm comply with ethical and independence requirements.

3. Establish an understanding of with the entity of the services and expectations.

What are the audit team requirements?

Assess size, complexity, and inherent risk of the engagement: Can your firm staff a team to meet these

needs?

o Extreme example: If you are considering your firms’ first publicly traded company, are you

registered with the PCAOB?

• Identify needs for specialized expertise and verify personnel availability and timing of work.

o Examples of specialized experts include complex estimates/valuation specialists, tax specialists,

IT audit specialists, standards specialists (specific transactions or different country standards)

Is the audit team AND audit firm adhering to ethics & independence standards from the AICPA Code of Professional Conduct?

• The AICPA is the national professional organization for all CPAs. The Code of Professional Conduct has

specific rules for ethical conduct and independence.

• Ensure strict compliance with the Code of Professional Conduct through annual independence

questionnaires and continuous monitoring.

• Partner must ensure audit team members and audit firm are in compliance throughout the audit. Here

are some examples you are responsible for:

Audit team members are not independent if

▪ Have a direct financial interest in a client.

▪ Have a material indirect financial interest in a client.

▪ Be a trustee or administrator of an estate that has a direct or material indirect financial

interest in a client.

▪ Have a joint investment with a client that is material to the covered member.

▪ Have a loan to or from a client, any officer of the client, or any individual owning more

than 10 percent of the client (except as specifically described in Interpretation 101-5).

▪ They were formally employed by the client in a position to influence the audit or acted as

an officer, director, promoter, underwriter, or trustee of a pension or profit-sharing trust

of the client.

Audit team members are not independent if their immediate family member has a direct

financial interest or material non-financial interest in the client.

o Audit team members are not independent if their close relatives hold key management

positions at the client, have material financial interest in the client (and it is known to team

members), or in a position to influence the client.

o Audit Firm is not independent if

▪ A partner or professional employee is associated with the client as an officer, director,

promoter, underwriter, or trustee of a pension or profit-sharing trust of the client.

▪ The client has not paid prior year’s fees.

▪ If the client is an issuer, Sarbanes-Oxley act prohibits audit firm providing most

consulting services to them.

Integrity and Objectivity Rule

▪ CPAs must remain free of conflicts of interest.

▪ Do not knowingly misrepresent facts.

▪ May not subordinate judgments to others.

▪ Do not knowingly make false or misleading entries in an entity’s financial records.

Acts Discreditable Rule:

A member shall not commit an act discreditable to the profession

(including, but not limited to):

▪ Making false or misleading journal entries.

▪ Failure to meet requirements of a Governmental body, commission, or regulatory body.

▪ Failure to file personal income tax return.

Professional Conduct Fees

Commissions: Receiving fees for recommending the products or services of clients or

third parties (non-CPA). CPAs can take commissions for non-attest clients, but cannot for

attest clients.

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o Advertising and solicitation of new clients is permitted.

▪ Advertising: Cannot be “false, misleading, or deceptive”.

▪ May not create false or unjustified expectations of favorable results.

▪ May not state ability to influence any court, tribunal, regulatory agency, or similar body

or official.

▪ May not underestimate fees (“low balling”).

▪ May not contain any other representation likely to cause a reasonable person to

misunderstand or be deceived

Confidentiality Client Information Rule

o CPAs shall not disclose any confidential information without the specific consent of the client.

o Exceptions:

▪ If workpapers are subpoenaed by court.

▪ As part of a PCAOB peer or quality review of practice.

▪ As part of an ethics violation for a state board of accountancy investigation.

Engagement Letter:

Scope of services provided.

o Auditor and management responsibilities, as well as engagement limitations.

o Timing of field work and fee structures.

o Arrangements regarding internal audit assistance or external specialists – more discussion below.

o Limitations of liability for the auditor or client (where permitted).

▪ SEC does not allow these restrictions.

▪ Nonissuer clients: Auditor may include indemnification clause to limit auditor if management

knowingly misrepresent information to them or to allow alternative mediation (arbitration,

mediation, etc. instead of court case).

o Arrangements regarding non-audit or additional services (if permitted).

▪ If permitted this could include other assurance, tax, consulting services