ACTG 435 Auditing Exam 1 Study

How is auditing different?

- Uses analytical and logical skills

- Much more conceptual in nature

What is the purpose of an audit?

To provide reasonable assurance that the financial statements are free of material misstatement

Why are audits demanded?

- Public companies are required to have audited financial statements

- Even if not public, banks require audits when giving loans

- Investors like company transparency from outside party

During the economic boom of the late 1990s and early 2000s, accounting firms aggressively sought opportunities to market various what?

high-margin non audit services

Sarbanes-Oxley Act (2002)

Regulation of audit profession and creation of PCAOB

Dodd-Frank Act (2010)

Expanded the Fed's regulatory authority over financial institutions & shaped the accounting profession and environment

Manager's responsibilities

Establish and maintain internal controls and ensure fair presentation of financial statements

Auditor's responsibility

Provide reasonable assurance that the financial statements are free from material misstatement

Overarching regulator of public companies

Securities and Exchange Commission (SEC)

SEC delegated power to who, who creates GAAP?

Financial Accounting Standards Board (FASB)

This board oversees and issues auditing standards for public companies

Public Company Accounting Oversight Board (PCAOB)

Private companies don't need to use GAAP, rather they follow standards set by the Auditing Standards Board, which is under the

American Institute of Certified Public Accountants (AICPA)

Due Professional Care

The care and skill expected of a reasonably prudent and competent auditor; exercise professional skepticism

Most valuable assets to accounting professionals

Unquestioned integrity and a solid reputation

A member in public accountancy must be_____________, both is fact and in appearancef

Independant

Independence applies to __________ _____________, which is anyone who can influence the audit engagement (partners, managers, senior associates, and associates)

covered members

PCAOB Inspections

A periodic inspection of the work conducted by auditors as well as the audit firm's quality control procedures which is conducted by the PCAOB.

3 Broad Areas of Judgement

- Evaluating evidence

- Estimating probabilities

- Deciding between options

Judgement Trap - "Rush to solve"

- Wanting to immediately solve a problem

- First solution not always the best

Judgement trap - "solving the wrong problem"

Ask the what and why questions

Judgement tendency - Availability tendency

consider information that is easy retrievable from memory (using previous year procedures and do the same thing)

Judgement tendency - Confirmation tendency

Seek and put emphasis on information that is consistent with our beliefs (over rely on management explanation of significant difference)

Judgement tendency - Overconfidence tendency

Overestimate our own abilites

Judgement tendency - Anchoring tendency

Insufficiently adjusting from an initial value when forming final judgement

What does the engagement letter do?

- Formalize contract with client

- Outline responsibilities of manager and auditor

- Explains limitations of the engagement

Who signs an engagement letter?

Audit committee and audit firm

Who hires and fires auditors?

Audit committee

Business risks

- Auditors must understand the entity's business and identify likely errors and risks that can occur and allocate more resources to riskier accounts

Define Materiality

The maximum amount financial statements can be misstated and not affect the decisions of the user

3 steps to applying materiality on an audit

1. Determine overall materiality

2. Determine tolerable misstatement

3. Evaluate auditing findings

How to determine overall materiality

- use quantitative benchmarks to establish materiality i.e. numbers, percentages

(Can be adjusted when considering qualitative facts like previous year misstatements, high risk of fraud, volatile business market, etc)

Determining tolerable misstatements

Taking the materiality threshold and allocating it into different financial statement accounts (accounts with greatest risks want lower thresholds)

Factors that could influence what percentages or amounts to allocate to tolerable misstatements for individual accounts?

- High risk of misstatement

- Accounting issues that are uncertain

- Deficiencies in internal control

- High management turnover

Evaluate audit findings

Give final opinion by aggregating misstatements

Consider Multilocations or Business Units

- If there are multiple locations, auditor must decide where to audit and test

- Facts to determine include by amount of regulation, environmental facts

Assess the Need for Specialists

- What type of specialists? IT? Tax? Actuary?

Related Party Transactions

- Need to be disclosed and investigated

- Should not be given favorable treatment

Supervisions of the audit

Audit partner ensures that all levels of review are comfortable with audit

3 Types of Audit Tests

-risk assessment procedures

-test of controls

-substantive procedures

Risk Assessment Procedures

- Used to obtain an understanding of the entity, environment, and internal controls

- Look at financials, compare to competitors, and establish risks and red flags

Test of controls

- Evaluating the effectiveness of design and operation of internal controls

- Test operating effectiveness of internal controls

Substantive Procedures

- Detect material misstatements in a transaction class, account balance, and disclose components of financial statements

- Details of testing accounts of financial statements, pulling invoices, reports, other analytical procedures

Dual purpose tests

Combining 2 audit tests so as not to double document

2 components of engagement risk

- litigation

- adverse publicity

Audit risk Model =

IR x CR x DR

Audit risk (AR)

Risk the auditor expresses an inappropriate audit opinion when statements are materially misstated

Inherent Risk (IR)

Susceptibility to a misstatement due to error or fraud

Detection risk (DR)

risk that auditor will not detect misstatements

3 components of audit risk model

1. Setting planned level of risk (generally low)

2. Assess the risk of material misstatement (IR x CR)

3. Determining the appropriate level of detection risk

Causes of misstatements

error and fraud

2 types of fraud

- fraudulent financial reporting (manipulation/misrepresentation)

- misappropriation of assets (theft)

Factual misstatements

exact misstatement known

Judgemental misstatements

disagreement between auditor and manager on judgement

Projected misstatements

Identified misstatement, and project factual misstatement to population

3 components of fraud risk triangle

- Incentive/pressure

- Opportunity

- Attitude or rationalization

Audit evidence

Information gathered by the auditors to arrive at their conclusions

3 components of audit evidence

1. Nature of audit evidence

2. Sufficiency and appropriateness

3. Evaluation of evident

Sufficiency

The measure of the quantity of audit evidence

Approprateness

Measure of the quality of audit evidence (sources independent? Quality of internal controls?)

Why should audit evidence be persuasive?

Reasonable person looking at documentation should be convincing so they make the same conclusion

Inspection of records and documents

Looking at invoices, reports, receiving orders (vouching and tracing)

Vouching

Verifying transactions were recorded in journals and ledgers (ensures they actually took place)

Tracing

verifying the source of documents (ensures they were recorded properly)

Confirmation

Very common, obtained by the auditor from 3rd pary

Inspection of tangible assets

physically inspecting assets

Observation

observe someone else do a procedure

Recalculation

mathematically checking numbers

Reperformance

re execute procedure

Inquiry

probing questions, listening

Scanning

review accounting data to find unusual problems

3 steps to analytical procedures

1. Risk assessment procedures (look for red flags)

2. Substantive analytical procedures (find evidence in particular accounts and assess relationships)

3. Final analytical procedures (explain everything)

Trend analysis

year to year comparison

Ration analysis

comparison to financial statement accounts

Reasonableness analysis

developing an expectation

Why is developing an expectation the most important step in the analytical procedure?

Precision is important and we need to get as close to the true, correct value

4 factos that affect precision

1. Disaggregation

2. Plausibility and predictability

3. Data reliability

4. Type of analytical procedure