A424 Exam 1

Chapter 1: Intro to Assurance and Auditing

Financial Statement Audit Overview

• Public companies need to put out an annual report (10K) with financial statements

• Management prepares financial statements

• Auditor has to be independent

• Audit committee hires the external auditor

• Auditors make risk assessments about complex transactions, weak controls, and issues in the industry to plan the audit

• Auditors collect evdience to support their opinion with reasonable assurance whether the financial statements as a whole are free of material misstatement due to error or fraud

• The audit opinion is included with the company’s annual report to the public and filed with the SEC

• Investors, creditors, and other stakeholders care about the audit report

Demands for auditing

• Audits are required by Securities Exchange Acts of 1933 and 1934 for publicly traded companies in the U.S.

  • Prior to 1933, 82% of companies already had independent audits

• Other demands for auditing

  • To raise capital (stocks, bonds, etc)

  • To fufill a stewardship function (managing the corporation’s assets)

    • Important role in the principal-agent relationship

Principal agent relationship

Assurance Services

Auditing is the highest level of assurance

What is auditing?

1. Systematic process (follows GAAS and uses a risk-based approach)

2. Objectivity collecting and evaluation evidence (independently and unbiasedly getting evidence on a test-basis)

3. Assertions are made by management (everything in the financial statements and footnotes

4. Assertions should conforn to specified rules (GAAP)

5. Results are reported to others (users are investors and creditors)

Management assertions balance sheet

Overview of the Financial Statement Audit Process

Major Audit Concept - Materiality

The magnitude of an omission or misstatement of accounting info that in light of surrounding cirumstances. makes it probable that the judgement of a reasonable person would have been changed or influence by the omission or misstatement
- Quantitiative and qualitiative considerations

Major Audit Concept - Audit Risk

Risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated
- Audit provides reasonable assurance that the FS do not contain material misstatements

The Audit Process

• Client acceptance/continuance = deciding whether to accept new clients and retain current clients

  • New clients, the auditor req to confer w the predecessor and do background checks on top management

• Prelim engagement act = determine audit team req, ensure independence of audit firm and team, understand services to be performed and terms of engagement —- understanding entity and environment 

• Planning = determine materiality, assessment of clients business risk, final plan sets the nature, timing, extent of the audit procedures to be performed

• Consider entity and audit internal controls 

• Audit business processes and related accounts = most of the time on a f/s audit or audit of internal control, for public companies, these are done tg

• Complete the audit = addresses issues like the possibility of undisclosed contingent liabilities, lawsuits, searches, etc

• Evaluate results and issue audit opinion

What is an unqualified report?

Means the financial statement is free of material misstatements, clean

It’s common for auditors to find misstatements but clients will fix

Audit report includes opinion on the financial statements, basis for opinion, and critical audit matters

Chapter 2: Financial Statement Auditing Environment

What did the Sarbanes-Oxley Act of 2002 (SOX) do?

1. Created the Public Company Accounting Oversight Board (PCAOB) to regulate public accounting firms

   • accounting firms must register with PCAOB

   • Set auditing standards

   • Conduct inspections on accounting firms

     • annually for large accounting firms (>100 public clients)

     • Triennially for small accounting firms (<100 public clients)

2. Under new independence rules, non-audit services were severely limited

   • No consulting or management functions for audit clients (bookkeeping, financial info systems design and implementation, valuation services, actuarial services, internal audit services, HR functions, legal or investment services)

   • Tax services are okay

3. A second partner review and approval for all audits

4. Lead audit partner and review partner rotate off every 5 years

5. Client’s CEO and CFO certify the financial statements and disclosures

• Penalties up to $5 million and 20 yrs of prison

6. One year cooliing off period - CEO, CFO, controller, anyone in financial reporting management cannot have been employed by the company’s audit firm within one year proceeding their audit

7. Management must assess and report on the effectiveness of internal controls over financial reporting (ICFR)

8. Required audit and audit opinion on effectiveness of ICFR

9. Audit committee must be independent; with at least one financial expert

What is Corporate Governance?

• To form a business, principals decide on the organizational form (corp, partnership) and hire managers to manage resources

• System of corporate governance oversees management

• It consists of all the people, processes, and activities in place to help ensure proper stewardship over an entity’s assets

• Good corporate governance ensures that those managing an entity properly use their time, talents, and entity’s resources in the best interest of the absentee ownners, and that they faithfully report the economic condition and performance of the enterprise

Model of a Business

1. Management, with guidance from the Board of Directors set objectives with strategies to achieve those objectives

2. Management then establish business processes to implement these strategies

   1. Bus. Processes include financing, purchasing, HR management, inventory management, and revenue processes

3. Business processes involve transactions

4. The enterprise designs and implements accounting information systems to capture the details of these transactions

5. Design and implement system of internal control to ensure transactions are handled and recorded appropriately and resources are protected

Audit Committee Characteristics

• Required for all publically traded companies

• 3-6 members

• independent outside directors

  • can’t accept any consulting, advisory, or other compensating fee from the company

  • can not be an affiliated person of the company or any of its subsidiaries

• Contain at least 1 member with financial expertise

  • based on education & work experience

  • understanding GAAP and FS

  • Experience with GAAP financial statements and internal controls

  • understanding of audit committee functions

  • typcial candidates = retired audit partners, financial officers, principal accounting officers

• If an audit committee lacks financial expertise, must disclose to SEC the reason why

Audit Committee Responsibilities

• Overseeing the financial reporting and disclosure process

• monitoring choice of accounting policies and principles

• oveseeing hiring, performance, and independence of the external auditors

• oversight of regulatory compliance, ethics, and whisteblower hotlines

• monitoring the internal control process

• overseeing the performance of internal audit

• discussing risk management policies and practices with management

Firms that have good governance…

• are less likely to engage in “financial engineering” and less risky to audit

• have a code of conduct reinforced by actions of top management and independent board members

• take the requirements of good internal control over financial reporting seriously

• make a commitment to financial competencies needed

Organizations that Affect Financial Statement Audits in the United States

PCAOB

• Established by SOX

• Quasi-gov regulatory agency overseen by SEC

• Consists of 5 board members with no more than 2 being CPAs

• Funded by over 1,850 audit firms that perform public company audits

• responsibilites

  • audit standard authority

  • inspections of registed audit firms (1 or 3 yrs)

  • Disciplinary authority over registered audit firms

Principles Underlying an Audit (in accordance with GAAS)

1. Purpose and premise of an audit

2. Responsibilites of the auditor

3. Performance of the Audit

4. Reporting

Purpose and premise of an audit

• Purpose is an opinion on the FS, in all material aspects, in accordance with GAAP

• Audit in accordance with GAAS (management is responsible for financial statements)

Responsibilites of the auditor

• having competence and capabilities to perform the audit

• complying with ethical requirements, including integrity & independence

• maintaining professional skepticism and exercising due professional care in professional judgement

Performance of the audit

• obtain reasonable assurance about whether the financial statements are free of material misstatements, whether due to error or fraud

• plan the work and properly supervise assistants

• determines and applies appropriate materiality levels throughout the audit

• identifies and assesses risks of material misstatements based on understanding the entity and environment, including the entity’s internal controls

• obtain sufficient appropriate audit evidence

• inherent limitations prohibit absolute assurance

Reporting

Express an opinion about whether the FS are presented fairly, in all material aspects, in accordance with GAAP

Chapter 19 - Professional Conduct and Independence

AICPA’s Principles of Professional Conduct

• Starts with preface that is applicable to all CPAs

  • Preface consists with preamble and principles, described below

• Starts at a conceptual level with principles → general rules → detailed interpretations

• 3 parts

  • Part 1 applies to CPAs in public practice, who provide assurance to audits which 3rd party stakeholders will rely

  • Part 2 applies to CPAs who are working in business but not as auditors, doesn’t require independence

  • Part 3 applies to CPAs who are neither 1 or 2 (such as professors)

Preamble - Principles of Professional Conduct

Principles guide members in the performance of their professional responsibilities and express the basic tenets of ethical and professional conduct. The principles call for an unwavering commitment to honorable behavior, even at the sacrifice of personal advantage.

Principles - Principles of Professional Conduct

1. Responsibilities: In carrying out their responsibilities as professionals, members should exercise sensitive professional and moral judgement in all their activities

2. The public interest: Members should accept the obligation to act in a way that will serve the public interest, honor the public trust, and demonstrate commitment to professionalism

3. Integrity: To maintain and broaden public confidence, members should perform all professional responsibilities with the highest sense of integrity.

4. Objectivity and independence: A member should maintain objectivity and be free of conflicts of interest in discharging professional responsibilities. A member in public practice should be independent in fact and appearance when providing auditing and other attestation services.

5. Due care: A member should observe professions’s technical and ethical standards, strive continually to improve competence and quality of services, and discharge professional responsibility to the best of the member’s ability.

6. Scope and nature of services: Member in public practice should observe the principles of the code of professional conduct in determining the scope and nature of services to be provided.

When is independence in mind/fact?

An auditor is independent in fact when they are objective and unbiased in their actions and decisions

• Threat to author’s professional judgements (actual bias)

When is independence in appearance?

An auditor is independent in appearance when they are perceived by knowledgeable users as independent

• Threat to auditor’s credibility and reputation

  • Ex. working on a engagement team where your best friend’s wife is in a position at the client that affects its financial statements may be independent in fact, but not in appearance.

When does independence matter?

• For all attestation services

  • Financial statement audits and reviews

• All covered members must be independent

Who is a covered member?

Any individual who is…

• on the attest engagement team

• in a position to influence the attest engagement

• a partner or manager who provides more than 10 hrs of nonattest services to the attest entity

  • Designation as a covered member ends on the later of the date the firm signs the report on the f/s for the fiscal year during which those services were provided or the date they no longer expect to provide 10 or more hours of nonattest services to the attest client on a recurring basis

• a partner in the office in which the lead attest engagement partner primarily practices in connection with the attest engagement

• the firm, including employees benefit plan

• an entity whose operating, financial, or accounting policies can be controlled by any of the individuals or entities described above or by two or more such individuals or entities if they act together

Independence - Prohibited Financial Relationships

• Direct financial interest: a financial interest that is owned directly by an individual or entity or is under the control of an individual or entity

  • Financial interest that is owned thru an intermediary (trust or estate) is also considered a direct financial interest

    • Ex. owning shares of the client’s stock

    • Can’t borrow, own, invest not even a cent

• Indirect financial interest: when a covered member has a financial interest in an entity that is associated with an attest entity

  • Ex. owning shares of a mutual fund that owns the client’s stock

    • impairs independence if your indirect interest is material (<5% net worth)

    • can’t own stock in an entity with a material relation with the client or one of a client’s related parties

Independence - prohibited business relationships

• Independence is impaired if CPA performs a managerial or other significant role for an entity’s org during the time period covered by an attest engagement

  • Non-attest services for attest clients

• A firm’s independence will be considered to be impaired with respect to an entity if a partner or professional employee leaves the firm and is subsequently employed by or associated with that entity in a key position unless a number of conditions are met

  • The one year cooling off period for oversight roles

Independence - Effect of family relationships

• A covered member’s immediate family (spouse or equivlent or dependent) is subject to rule 101 and its interpretations and rulings

  • 100% of independence rules apply to immediate family

• A covered members close relatives can impair independence if

  • Close relatives = nondependent children, brothers, sisters, parents, grandparents, parents in law and their respective spouses

  • member’s close relative could influence signficiant influence over the financial or accounting policies of the entity (FR oversight role in client)

  • member’s close relative has a material financial interest in the entity

Independence - Effect of litigation

Independence is impaired when

• Management sues the auditor, claiming the auditor did poor audit work.

• Management clearly says it intends to bring that kind of lawsuit.

• The auditor sues management, claiming management committed fraud or deceit.

Independence - Provision of Nonattest services

• AICPA Code of Professional Conduct restricts the types of nonaudit services that can be provided to attest clients. Examples include

  • authorizing, executing or consummating a transaction on behalf of an entity

  • Preparing source documents evidencing the occurrence of a transaction

  • having custody of entity assets

  • supervising the entity’s employees

  • determining which recommendations of the member should be implemented

  • establishing for maintaining internal controls

• The SEC (mandated by SOX) has even more restrictive independence rules for audits for public companies

  • providing nonattest services is only okay if allowed, approved by audit committee, and disclosed

Independence - SEC and PCAOB Independence requirements for audits of public companies

• SEc rules are predicated by 3 basic principles of auditor objectivity and independence

1. An auditor should not audit his own work

2. An auditor should not function in the role of management

3. An auditor should not serve in an advocacy role for the tntity and should not have a mutual or conflicting interest with an audit client

• Ex: bookkeeping, financial info system design and implementation, appraisal or valuation services, actuarial services, internal audit outsourcing services, management functions or human resources, broker or dealer, investment advisor, or investment banking services, legal or expert services

Disciplinary actions

• AICPA can discipline members for violating the code of professional conduct

  • membership in AICPA can be suspended or terminated

  • CPA license can be suspended or revoked

• PCAOB inspects all registered firms for compliance

Chapter 3: Audit planning, types of tests and materiality

Client Acceptance and Continuance

Auditors have to make decisions about:

• accepting new clients

  • is the firm capable? (consider firm personnel, specialists, if able to complete by reporting deadline, independent)

  • does the firm comply with legal and ethical requirements?

  • how is the client’s integrity?

    • Inquiries of the predecessor auditor, inquire other firm personnel or third parties (bankers, legal counsel, industry peers), background searches of relevant databases

(SIM - skills, independence, management risk/integrity)

• Continuing with existing clients

  • Evaluate client relations periodically

What should successor auditor ask predecessor auditor (Required communications)

• Information that might bear on the integrity of management.

• Information regarding identified or suspected fraud and matters involving noncompliance with laws and regulations.

• Disagreements with management about accounting policies, auditing procedures, or other similarly significant matters.

• Communications to audit committees or others with equivalent authority and responsibility regarding fraud, illegal acts by clients (i.e., noncompliance with laws and regulations), and internal-control-related matters.

• The reasons for the change of auditors.

• Any significant related parties or unusual transactions

Continuing with Existing Clients

• Evaluate client retention periodically

  • Near audit completion

  • After a significant event (conflicts over accounting or audit issues, dispute over audit fees)

• All public companies must disclose auditor changes in SEC 8-K filing, including reason for change

What are reasons for audit firm to dissociate from client?

• Disagreement between client/auditor

• Auditor not willing to accept audit risk or business risk

• Auditor/client misalignment (company grows or shrinks and needs a larger/smaller auditor)

Preliminary Engagement Activities

1. Determine audit team requirements
   - look at size, complexity, level of risk, any special expertise, availability, timing of work

2. Assess compliance with ethical and independence requirements

   • Ensure independence is maintained!

   • many firms have policy of not completing current audit until all of prior year fees have been paid

3. Establish an understanding of the entity

   • Engagement letter

   • using work of internal auditors

   • role of the audit committee

What is the engagement letter?

• a contract oulining the responsibilities of both parties and preventing misunderstandings between the two parties

• addressed to the chair of the audit committee

What does the engagement letter include?

• services to be performed and related reports

• auditor’s responsibilities and limitations

  • objective of the audits

  • summary of the audit procedures to be performed and evidence that will be obtained

  • limitations of the audit

• management responsibilities

  • expectations regarding f/s prep and responsibility for ICFR

  • expectations for making evidence available on a timely basis

  • expectations about management representation letter (written represenations about the f/s)

• Timing and fees

  • establish timeline for audit work performance

  • details on an estimate of audit fees (breakdown by level of auditor)

  • agreed upon assistance from the company personnel (specialists or internal auditors)

Using the work of internal audit function

• auditor can use the work of internal audit as evidence and request IA to provide direct assistence in the external audit

  • obtain an understanding of IA

    • objectivity

    • competence

    • systematic and disciplined approach (do they adequately document their IA produres or guidance covering areas like risk assessments, work programs, documentation, quality control)

  • If IA is reliable, audit can use IA work to reduce audit work

  • if auditors rely on IA, then they must supervise, review, evaluate, and test IA work

Planning the audit

• Develop audit strategy and plan (nature, extent, timing of testing)

  • assess business risks (understand entity & environment)

  • establish materiality

  • consider multi-locations or business units (which locations are audited and what to audit at each location or bus unit)

  • assess the need for specialists (specialists in finance, valuation, legal, etc)

  • consider violations of laws and regulations (securities acts, enviornmental protection, price-fixing, etc)

  • identify related parties (RP = affiliates, investments under equity method, trusts for benefit of employees, pension, principal owners and their immediate families)

  • consider additional value-added services

  • doc the overall audit strategy, plan, and prepare audit programs

Identify Related Parties

• Auditor must evaluate the entity’s identification of, accounting for, and disclosure of transactions with related parties

  • identify if transactions are “at arms length”

  • examples of “related parties”

    • affiliates of the entity

    • entities using equity method to account for investment

    • trusts for benefit of employees

    • principal owners of entity

    • managment

    • immediate families of principal owners and management

    • other parties that can have significant influence

How do auditors identify related parties and related party transactions?

• Inquire if management and other about names of related parties, reasons for transactions with the RP

• minutes of the board of director meetings

• conflict-of-interest statements from management and others

• financial and reporting info provided to creditors, investors, and regulators

• contracts or other agreements (including side agreements that may not be formally documented between customers and vendors, and management)

• contracts and other agreements representing significant unusual transactions

Example of RP is a partnership composed of management who owns a building leased by the entity, auditor would examine lease agreement

Type of audit tests

• risk assesment procedures

• tests of controls

• substantive procedures

• dual purpose tests

Risk assessment procedures

Used to obtain an understanding of the entity and its environment, including its internal control

• includes inquiries of management and others, preliminary analytical procedures, observation, and inspection

Tests of controls

Test the operating effectiveness of controls in preventing or detecting & correcting material misstatements to the f/s

• Inquiries of appropriate management, supervisory, and staff personnel.

• Inspection of documents, reports, and electronic files.

• Observation of the application of specific controls.

• Walkthroughs, which involve tracing a transaction from its origination to its inclusion in the financial statements through a combination of audit procedures, including inquiry, observation, and inspection.

• Reperformance of the application of the control by the auditor.

Substantive procedures

Tests to detect material misstatements (monetary errors) in transactions, account balance, or disclosure in f/s

Includes

1. test of details

   • substantive tests of transactions to detect errors or fraud in individual transactions

   • test of details of account balances and disclosures

2. substantive analytical procedures

   • Evaluations of financial info thru analysis of plausible relationships among both financial and nonfiancial data (examination of trends and errors)

Dual Purpose tests

tests of controls and substantive tests simulatieously on the same document

Materiality

• Matter of professional judgement

• misstatements, including omissions, are material if theres a high likelihood that individually or in aggregate, they would influence the judgement made by a reasonable user of financial statements

• affected by size or nature of a misstatement or both (quantitative & qualitiative)

Steps in applying materiality on an audit

1. determine overall materiality (Planning materiality PM)

2. Determine tolerable misstatement (TM): allocation of materiality to individual account/class of transactions level)

3. Evaluate auditing findings: near the end of the audit, examine individual and aggregate misstatements)

Detemine overall materiality (PM)

Auditing standards require auditors to establish materiality threshold for financial statements as a whole

• PCAOB guidence: auditor should consider company’s earnings and other relevant factors

• ASB: provides additional guidance on fiancial statement balances to consider

PM is the maximum amount by which the auditor feels that the fianncial statements can be misstated and not affect the decisions of users.

Considerations for PM

• Quantitiative basis

  • Based off a range of pretax income by default, total sales/rev, total equity, total assets, or net assets

• Qualitiative considerations for quantitiative basis of materiality

  • use the low end range of quantitative materiality for factors such as

    • material misstatements detected during prior year

    • high risk of fraud

    • potential loan convenant violations or going concern issues

    • high market pressures

    • volatile business environment

    • higher than normal risk of bankruptcy

• High end of the range quantitiatve materiality is rare and needs very convincing documentation

Determine Tolerable Misstatement (TM)

• TM: amt or amts that reduce to an appropriately level the probability that the total of uncorrected and undetected misstatements would result in a material misstatement of the financial statements

• Typically 50-75% of PM depending on risk

• Purpose of TM

  • establish a scope for the audit procedures over individual account balances

  • audit all account balances over the threshold

  • assumption is errors in any account below threshold wouldn’t generate misstatements that would result in a material misstatement

  • serves as a safety net

Evaluate audit findings

• occurs near end of audit

• aggregate misstatements from each amount or disclosure for all misstatements over the de minimum threshold (2% of PM)

• When evaluating aggregate misstatements, include the current year effect of misstatements not adjusted in the prior year that were immaterial

• if aggregate misstatements at account level > TM = adjust financial statements and consider qualitiative factors

• If remaining total aggregate misstatement for all PM = adjust f/s and consider qualitiative factors

• considerations from misstatements that are estimates

Chapter 4: Audit Risk Assessments

Audit Risk

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

Two components

• risk that account balances and disclosures contain material misstatements (inherent & control risk)

• risk that the auditor will not detect such misstatements (detection risk)

Audit risk model

(is adapative to the account)

• RMM is inversely related to AR

• DR directly related to AR

• IR and CR are inversely related to DR

Inherent risk (IR)

Risks related to entity and its environment (beyond auditor’s control)

Control risk (CR)

(unrelated to inherent risk)

Function of the effectiveness of the design and operation of intenral control

Detection risk (DR)

Risk that the procedures performed by an auditor to reduce audit risk to an acceptably low level will not detected a misstatement that exists and that could be material

• determined by effectiveness of the auditor

  • DR is caused by:

What is detection risk caused by?

• inappropriate audit procedures

• improper or incomplete use of appropriate audit procedures

• mistinterpretation of results from an audit procedure

How to reduce detection risk?

• adequate planning, supervision, review, PS, etc

• the lower the detection risk, the more substantive testing required

• controlled by the auditor in planning

How to use the audit risk model

1. set a planned level of audit risk (AR)

   • determined based on risk of client (engagement/business risk)

   • set at low or very low level

2. assess the risk of material misstatement (RMM)

   • range from very low to very high

3. solve for appropriate level of detection risk (DR)

   • Use DR to design audit procedures that will reduce AR to an acceptably low level (the nature, extent, and timing of testing)

When setting audit risk (AR), consider…

1. RMM

2. The auditor’s risk

• The risk that the auditor is exposed to financial loss or damage to his or her professional reputation from litigation, adverse publicity, or other events arising in connections with f/s audited and reported on

Global factors that impact engagement risk

• num of users of f/s

• integrity of management

• financial health of the company

• company’s industry charactersitics

Auditor’s assessment of client’s business risk

Risks resulting from signficiant conditions, events, circumstances, and actions or inactions that could adversely affect management’s ability to execute its strategies and to achieve its objectives, or through the settting of inappropriate objetives or strategies

• Most business risks have the potential to affect f/s

• auditors have to identify potential business risks and understand the potential material misstatements that may result

Examples of business risks (IR and CR)

• Nature of entity

  • org structure, management personnel, sources of funding - including capital structure, noncapital funding, and other debt instruments, investments, size and complexity, relative profitability of key products and services, key supplier and customer relationships

• Industry, regulatory, external factors

  • industry conditions - market & competition, cyclical or seasonal activity

  • reglatory environment - accounting principles such as industry specific practices, regulatory framework for a regulated industry, taxation, government policies, environmenal reqs

  • Other external factors = general level of economic activity, interest rates, inflation

• Objectives, strategies, and related business risks

  • industry developments, new products and services, expansion, use of IT, effects of implementing a strategy

• Entity Performance measures

  • Budgets, variance analysis, performance reports, comparison to industry peers, analyst expectations, credit ratings, profitability and liquidity ratios

• Internal control effectiveness

  • active and qualified board of directors, independent audit committee members, effective risk assessment process, competent and objective internal audit function, controls related to proper authoriztion of transactions, ensuring assets exist, monitoring of controls

types and causes of misstatements - RMM

1. Errors (unintentional acts)

2. Fraud (intentional acts)

   1. m/s from fraudulent financial reporting

   2. m/s from misappropriation of assets

Misstatements due to errors or fraud include

• inaccuracy in gathering or processing data from which financial statements are prepared

• omission of an amount or disclosure

• a f/s disclosure that is not presented in accordance with GAAP

• An incorrect accounting estimate arising from overlooking or clear misinterpretation of facts

• judgements of management concerning accounting estimates that the auditor considers reasonable or the selection or application of accounting policies that the auditor considers inappropriate

Two types of fraud

Fraud risk assessment process

During planning, auditors are required to assess the risk of material misstatement due to fraud

• Fraud brainstorming session - discussion among the audit team members about the risks and opportunities for fraud at the company this year

• inquire of management and others abt their views on the risks of fraud and how it is addressed

  • managment, audit committee, internal audit function

• Consider any unusal or unexpected relationships that have been identified in performing analytical procedures in planning the audit

• understand the client’s period-end closing process and investigate unexpected period-end adjustments

The fraud triangle

3 conditions are generally present when material misstatements due to fraud occur

1. incentive/pressure: motivation or reason to commit the fraud

2. opportunity: circumstances exist that allow the opportunity to commit the fraud

3. rationalization/attitude: one is able to justify commiting the fraud, or some individuals possess an attitude, character, or set of ethical values that allow them to commit dishonest acts

• Even honest individuals can commit fraud in an environment where sufficient pressure exists, and the greater the pressure the easier it is to rationalize

• Fraud can only take place when there is an opportunity!!

Incentives/Pressures for fraudulent reporting

• financial distress due to economic, industry, or entity operating conditions

  • ex. recurring operating losses or negative cf

• execssive pressure for management to meet requirements or expectations

  • analyst expectations, earnings growth, positive earnings, exec compensation tied to performance targets, meeting debt covenet restrictions, adverse financial results impact significant pending transactions

• management’s personal situation threatened by entity’s financial performance (getting fired)

Opportunities for fraudulent reporting

• weak internal controls

• signficiant related party transactions

• signficicant subjective accounting estimates and/or uncertainty

• unsual or highly complex transactions

• ineffective monitoring of management by BOD or AC (weak corporate governance)

• single person dominates management

• complex or unstable organziational structure

(difficult to detect when management overrides controls, and if collusion occurs)

Attitudes/rationalization for fraudulent reporting

• ineffective communication, support, or enforcement of values/ethics

  • tone at the top, lack of code of conduct

• history of violations of securities laws or other regulations

• excessive interest by management in maintaining or increasing the stock price or earnings trends

• a practice of management committing to aggressive or unrealisitic forecasts

• recurring attempts by managemnt to justify marginal or inappropriate accounting on the basis of materilaity

Fraud risk factors for misappropriation of assets

• incentives/pressures

  • employees with personal financial obligations/troubles

  • adverse relationships between entity and its employees (expected layoffs, not being promoted or rewarded as expected)

• opportunities

  • circumstances that make assets suscpetible to theft (large amts of cash on hand)

  • inadequate internal controls (lack of segregation of duties, lack of physical controls, lack of system access controls)

• attitudes/rationalizations

  • disregard for the need for monitoring and maintaining effective controls

  • changes in behavior or lifestyles that indicate assets have been misappropriated

Auditor’s response to pervasive risks

Pervasive risks affect the entire financial statement as a whole

• Ask: Could this cause errors in many places, or just one place?

If it is a pervasive risk, then need to

• emphasize the need for professional skepticism in gathering and evaluating evidence

• assign more experienced staff or use specialists

• provide more supervision

• incorporate more unpredicatability in selection of testing

Auditor’s response to specific risks

• At the mangement assertion level

• Perform tests of controls and substantive tests that directly respond to the specific risks

If the misstatement is or may be the result of fraud, and the effect could be material, the auditor should…

• attempt to obtain audit evidence to determine whether, in fact, material fraud has occured, and its effect

• consider implications for other aspects of the audit

• discuss the matter and approach to further investigate with appropriate level of management that is at least 1 level above those involved in committing the fraud

• suggest the approporiate level of management consult with legal counsel

• communicate with the audit committee

• consider withdrawing from the engagement