Fin Statement Audit - Exam 1

Completed Topics 1-5, Need 6-9 and the Readings

Auditing vs Accounting

Accounting is the processing and generation of financial statements from the operations of an organization. Auditing is the review of those financial statements against accounting standards with an opinion given after the review.

What creates the demand for auditing

Audits lend credibility to the information by reducing information risk of financial statements. Auditors give reasonable assurance that financial statements are free from material misstatements.

Explain the difference between Assurance, Attestation, and non-assurance services

Audit sits inside of Attestation, both are a subsection of Assurance, and non-assurance services (consulting & tax) are outside of both.

Exogenous Demand

Demand for assurance is imposed as a result of outside intervention (i.e. - SOX, SEC, etc)

Endogenous Demand

Demand from within the firm (not required by law) for assurance services.

Arguments for Endogenous demand for audits

Signaling, Monitoring, Information-risk reduction, and Insurance

Signaling (1 of 4)

“Signals” to investors/creditors that product is of high quality

Monitoring (2 of 4)

Owners/Managers demand for audit to “monitor” the operations of their organization (maximize own self-interest).

Information-Risk Reduction (3 of 4)

Investors need reliable information to make decisions, audits provide credibility to the financial statement’s information.

Insurance (4 of 4)

Auditors have money and liability insurance, so investors can sue to recover losses if the statements turn out to be wrong.

Types of Audits

Financial Statement Audits, Internal Control Audits, Compliance Audits, basically any operation of a firm can be audited

Purpose of audits

To review how a company operates and see if there is end need to make changes (whether that “need” is a legal requirement or a efficiency recommendation) or review things like financial statements to confirm if they have been done correctly.

Who performs the different types of audits?

CPA Firms, Internal Auditors, GAO Auditors, IRS Agents, etc

Professional Judgement

The process of reaching a decision or drawing a conclusion where there are a number of possible alternative solutions.

Which of the following best describes the relationship between professional skepticism and professional judgment?

a. Professional skepticism is an attitude that includes a questioning mind and a critical assessment of audit evidence that is separate and apart from the process of exercising professional judgment.

b. Professional skepticism is an attitude that includes a questioning mind and a critical assessment of audit evidence that is part of the process in forming professional judgments.

c. Professional skepticism is synonymous with professional judgment.

d. T here is no relationship between professional skepticism and professional judgment.

b. Professional skepticism is an attitude that includes a questioning mind and a critical assessment of audit evidence that is part of the process in forming professional judgments.

Professional Skepticism

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

Heuristics

Mental shortcuts that makes the judgement process more efficient and less cognitively demanding.

Biases

Systematic errors in judgement resulting from the use of heuristics and/or the influence of external factors.

Confirmation Bias

Auditors often search for and overweight evidence that agree’s with the idea that they already have in their head.

Anchoring Bias

Setting an initial numerical value and then insufficiently adjusting away from that “anchor”.

Availability Bias

Considering easily accessible information as more relevant or important.

Overconfidence bias

Tendency to overestimate your own abilities to perform tasks or make judgements

Skepticism Continuum

Range of “Trust and doubt” that exists for a given item. Ranges from Complete Trust » Neutral » Presumptive Doubt » Complete Doubt. Auditors should NEVER exist in the complete trust area of this continuum.

Elements of Professional Skepticism (6 Total)

1) Questioning mindset - inquire with some sense of doubt

2) Suspension of judgement - withholding judgement without evidence

3) Search for knowledge - desire to investigate

4) Interpersonal understanding - recognition of people’s motivations

5) Autonomy - self direction and moral independence

6) Self-esteem - Self-confidence in abilities

ASB Standards

Sets auditing standards for private companies and other entities in the United States. Part of the AICPA

PCAOB Standards

Oversight for auditors of public companies. Includes setting standards, performing audit inspections, and enforcing rules and regulations.

According to the academic reading, DeAngelo, which firms does she suggest have higher audit quality?

Smaller Accounting Firms

Larger Accounting Firms

Larger Accounting Firms - Small firms rely too heavily on the fewer number of clients that they have.

AICPA Code of Professional Conduct

Responsibilities, The Public Interest, Integrity, Objectivity and Independence, Due Care, and Scope and Nature of Services.

Why is quality control important to the delivery of assurance services?

Quality control ensures the firm meets its professional responsibilities to its clients.

Generally Accepted Accounting Standards (3 Total)

Responsibilities - “Who We Are”: Competence, Comply w/ ethical standards, be skeptical
Performance - “What We Do”: Do the right work, in the right way
Reporting - “What We Say”: Express an opinion

Ethics

refer to rules provided by an external source (i.e. Code of Conduct)

Morals

refer to the individual’s own principles of right and wrong

Independence in appearance vs Independence in fact

In appearance is how the auditor looks to reasonable outside observers; in fact is the actual state of mind of the auditor. Independence in fact is MORE IMPORTANT

Independence Rules

Basically summarized as having no direct or material financial ties to clients and their members / shareholders. Managers cannot act as a promoter, underwriter or equivalent to an employee.

Independence Rules - Immediate Family

Immediate family members have the same restrictions as the member (no direct or material financial interest or hold position / influence with an audit client)

All immediate family members and parents, siblings, or non dependent child cannot:

Own or control an audit client or work with a client in an audit sensitive position.

Franz Marteens is a CPA, but not a partner, with three years of professional experience with Roberts and Batchelor, CPAs. He owns 25 shares of stock in an audit client of the firm, but does not take part in the audit of the client, and the amount of stock is not material in relation to his total wealth.

No. Franz does not meet the definition of a covered member.

What constitutes a covered member?

member of the engagement team.

In a position to influence the engagement.

a partner in the office where the audit is performed.

Morris and Williams, a regional CPA firm, is providing information systems consulting to one of their publicly traded audit clients. They are assisting in the implementation of a new financial reporting system selected by management.

Independence Issue?

Yes

No

Yes. Morris and Williams CPAs provide attest services to this publicly-traded client.

Reasonable assurance is:

A low level of assurance

A moderate level of assurance

A high, but not absolute level of assurance

Absolute level of assurance

A high, but not absolute level of assurance

What do the Standards mean by “free from material misstatement”?

Misstatements are usually considered material if the combined uncorrected errors/fraud in the financial statements would likely have changed or influenced the decisions of a reasonable person using the statements.

Why do auditor’s generally divide the audit into financial statement cycles/segments?

Allows them to divide up transactions and accounts based on the specific cycle that they are working on. These accounts are closely related and allow for more effective auditing. (i.e. Inventory cycle, payroll cycle, etc)

Management assertions

implied or expressed representations by management about classes of transactions and the related accounts and disclosures in the financial statements.

Five Primary PCAOB assertions

1) Existence / Occurrence

2) Completeness

3) Valuation or Allocation

4) Rights and obligations

5) Presentation and disclosure

Existence / Occurrence

Existence refers to assets existing, Occurrence refers to transactions existing (except transactions don’t “exist” so we use the term occurrence)

Completeness

All items / events that should have been recorded have been recorded

Valuation or Allocation

Items that have been recorded are recorded at proper amounts

Rights and obligations

Company holds / controls rights to assets and liabilities

Presentation and Disclosure

All components of the financial statements are properly classified, described, and disclosed.

For the Accounts Receivable account balance, which assertion is likely to be assessed as higher risk?

Completeness

Existence

Existence - more of a risk of overstating assets than understating them. Completeness is a risk of understatement.

Responsibilities of management and the auditor

It is the responsibility of the auditor to conduct the audit and give an opinion about the financial statements, but management must prepare and certify those financial statements (i.e. They are the ones on the hook for them)

Factors that make audit evidence more persuasive

Appropriateness - Relevance and Reliability

Sufficiency - Sample Size

For audit evidence to be compelling to the auditor it must be sufficient and appropriate. Which statement below is not correct regarding the appropriateness of audit evidence?

a)The more effective the internal control system, the more assurance it provides the auditor about the reliability of financial reporting by the client.

b)Information included a letter written by the client’s attorney discussing the likely outcome of outstanding lawsuits against the client is generally more reliable than confirmations obtained from banks.

c)Evidence obtained from independent sources outside the entity is generally more reliable than evidence secured solely within the entity.

d)The independent auditor's direct personal knowledge, obtained through observation and inspection, is generally more persuasive than information obtained indirectly.

b)Information included a letter written by the client’s attorney discussing the likely outcome of outstanding lawsuits against the client is generally more reliable than confirmations obtained from banks.

Types of Audit Evidence

1) Physical Examination

2) Confirmation

3) Inspection

4) Analytical Procedures

5) Inquiry

6) Recalculation

7) Re-performance

8) Observation

Physical Examination

The inspection or count of a tangible asset by the auditor

Confirmation

The receipt of a direct written response from a third party verifying the accuracy of information that was requested by the auditor.

Inspection

The auditor’s examination of the client’s documents and records to substantiate the information in the financial statements.

Analytical Procedures

The evaluation of financial information through analysis of plausible relationships among financial and nonfinancial data and are required during planning and completion phases of all audits

Inquiry

Obtaining written or oral information from the client in response to auditor questions. Usually not considered conclusive unless it is corroborated

Recalculation

Rechecking a sample of calculations made by the client.

Reperformance

The auditor’s test of client accounting procedures or controls

Observation

Watching a process or procedure being performed by others.

Audit Documentation

Audit documentation is the principal record of auditing procedures applied, evidence obtained, and conclusions reached by the auditor in the engagement.

Purposes of audit documentation

Provides the basis for planning the audit, provides a record of the evidence accumulated and results of tests, provides a basis for review, and provides data for determining the proper type of audit report.

Audit Evidence Decisions

Four decisions about what evidence to gather and how much of it to accumulate:
1) Which procedures to use (nature)
2) When to perform the procedures (timing)
3) Which items to select from the population (extent)
4) What sample size to select for a given procedure (extent)

Retention requires

Private Company - 5 years, Public Company - 7 years

Acceptable Audit Risk

A measure of how willing the auditor is to accept that the financial statements may be materially misstated after the audit is completed and an unmodified opinion has been issued.

Client Business Risk

The risk that the entity fails to achieve its objectives or execute its strategies.

Risk of Material Misstatement

The risk that the financial statements contain a material misstatement due to fraud or error prior to the audit.

Auditor is unlikely to accept a new client or continue serving an existing client if the risk associated with the client is _____ than the risk the firm is willing to accept.

Auditor is unlikely to accept a new client or continue serving an existing client if the risk associated with the client is GREATER than the risk the firm is willing to accept.

Accepting a New Client (Initial engagement)

They view the company and look at its financial stability, reputation/standing, business risks. This part is the same as what an investor does for a stock. The auditors also look internally to see if they have the appropriate experience. They also look for any integrity disputes and why the firm is looking for a new auditor.

Continuing to Serve an Existing Client (Continuing Engagement)

Conflicts on prior audits? Ethical issues (does the firm lack integrity)? Major changes in the business practice?

Understanding the Client’s Business and Industry

The auditor identifies and assesses risks of material misstatement, whether due to error or fraud, based on an understanding of the entity and its environment, including the entity’s internal control.

Client business risk

The risk that the client will fail to achieve its objectives. (Economic downturns? Difficult industry? Unreasonable objectives?)

Analytical procedures are ______ during the planning phase of the audit.

Analytical procedures are REQUIRED during the planning phase of the audit.

Standards require auditors to plan and perform the audit to obtain _______ assurance about whether the financial statements are free of ______ misstatement.

Standards require auditors to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement.

Why are analytical procedures required during the planning phase?

To identify potential risks of material misstatement.

To assist in determining the nature, timing, and extent of audit procedures.

Materiality

materiality as the magnitude of misstatements that individually, or when aggregated with other misstatements, could reasonably be expected to influence the economic decision of users.

Common Materiality benchmarks

Net Income before taxes: 5-10%
Net Sales: 0.5-2.0%

Auditors must ______ all relevant decisions and judgments

Auditors must DOCUMENT all relevant decisions and judgments

If an auditor establishes a relatively high level for materiality, then the auditor will:

accumulate more evidence than if a lower level had been set

accumulate less evidence than if a lower level had been set

accumulate approximately the same evidence as would be the case were materiality lower

accumulate an undetermined amount of evidence

accumulate less evidence than if a lower level had been set

Planning Materiality vs Performance Materiality

Planning materiality covers everything (big picture) whereas performance materiality focuses on specific accounts (usually 50%-75% of planning materiality). Remember the case we had to work on.

Known vs Likely errors

Known misstatements - Auditor can determine the amount of misstatement in the account.

Likely misstatement - Auditor cannot determine the actual amount of misstatement in the account.

Components of RMM (Risk of Material Misstatement)

Inherent Risk & Control Risk

Inherent Risk

likely an account is to contain a mistake in the first place, before any controls are considered. Some accounts are naturally riskier: complicated ones, estimates, and assets that are easy to steal.

Control Risk

how likely it is that the company’s own internal controls won’t catch the mistake. Strong controls (approvals, reviews, separating duties) mean low CR. Weak controls mean high CR.

A ______ ______is any risk that the auditor deems to require special attention.

A SIGNIFICANT RISK is any risk that the auditor deems to require special attention.

Audit Risk Model

AAR = IR x CR x DR
Acceptable Audit Risk = Inherent Risk x Control Risk x Detection Risk

Detection Risk

how likely it is that the auditor’s own tests will miss the mistake. This is the only one the auditor controls. More testing means lower PDR.

When an auditor increases the assessment of the risks of material misstatement because certain controls were determined to be ineffective, the auditor will most likely increase the:

Extent of substantive tests of details.

Assessed inherent risk.

Extent of tests of controls.

Planned detection risk.

Extent of substantive tests of details.

Situations	AAR  (SET)	IR  (ASSESSED)	CR  (ASSESSED)	PDR  ?	Evidence needed  ?
PP&E purchase and repayment segment	Low	Low	Low
Investments   segment	Low	Low	Medium
Sales and collections segment	Low	High	High
Acquisition   (of another entity)	Very Low	High	High

Situations	AAR  (SET)	IR  (ASSESSED)	CR  (ASSESSED)	PDR  ?	Evidence needed  ?
PP&E purchase and repayment segment	Low	Low	Low	High	Low
Investments   segment	Low	Low	Medium	Medium	Medium
Sales and collections segment	Low	High	High	Low	High
Acquisition   (of another entity)	Very Low	High	High	Low	High

Key for The AAR calculations (High, Medium, Low, etc)

IR and CR inversely affect DR (PDR) in the same way PDR inversely affects evidence needed.

Types of Audit Reports

Unmodified (Unmodified with explanatory paragraph), Qualified, Adverse, Disclaimer

Parts of the Standard Audit Report

Title, Auditor report Address, Auditor Opinion, Basis for Opinion, Key Audit Matters, Management’s responsibility, Signature and Address for CPA, Audit Report Date

Unmodified vs Unqualified

AICPA uses unmodified & PCAOB uses unqualified (also PCAOB uses CAMs instead of KAMs)

Differences between Public and Private audit reports

KAMs are option, CAMS are required (public company). Public company auditors must be registered. Public companies must disclose how long their auditor has worked for them. Public company auditors must include internal control audits as part of their financial statement audit.

Dating the Report

End of fieldwork is standard (last day work is complete), if a subsequent event occurs prior to issuance, the report can either use the date of the subsequent event or dual-date using both.

The PCAOB auditing standards ______ communication of “critical audit matters” in the standard unmodified audit report

The PCAOB auditing standards REQUIRE communication of “critical audit matters” in the standard unmodified audit report. Critical audit matters, if disclosed, are included in a section following the Basis for Opinion section.

Analytical procedures

Analytical procedures are evaluations of financial information made by a study of plausible relationships among financial and nonfinancial data … involving comparisons of recorded amounts … to expectations developed by the auditor.

When do auditors use analytical procedures?

Planning (required)

Substantive Testing

Completion (required)