Auditing Final Exam - New Material

Review Cards for the Cumulative Final Exam

How is materiality reflected in the audit report?

“free from material misstatement”

How is risk reflected in the auditor’s report?

• Examining evidence

• Test basis

• Reasonable basis

When must audit risk and materiality be considered together?

In designing the NET of audit procedures and in evaluating the results of those procedures

How do audit risk and materiality jointly reflect the application of GAAS?

With sufficient, appropriate evidence

How are the financial statements linked together?

• Double-entry accounting

• Articulation (inter-relationship and congruence)

What is an implication of articulation and cycle-based auditing?

If the BS accounts are fairly stated, this provides some comfort and evidence that the income statement accounts are also fairly stated

What accounts do auditors historically spend more time auditing?

Balance sheet accounts

• Cash, AR, inventory

What do the balance sheet accounts provide evidence on?

Income statement account

• revenue

• COGS

What is COGS a plug in?

Substantive analytical procedures

What accounts does revenue affect?

Both cash and AR.

What does the PCAOB require firms to do over revenue?

Perform substantive tests of details over revenue

How does the allowance for doubtful accounts impact the balance sheet?

It ensures that AR is properly valued on the balance sheet. Collectibility of AR % is important

What are the most risky assertions for sales revenue?

Existence and Rights and Obligations

What internal controls are necessary for sales revenue?

Controls over recording of sales, credit, shipping, billing, and receipts/

What substantive tests are done for the existence of sales revenue?

• Substantive analytical procedures

• Cut-off testing

• Detailed testing of sales transactions (sales orders, sales invoices, shipping documents (now required by PCAOB))

• Rely on testing over Accounts Receivable and Cash (articulation)

How to get evidence about rights and obligations?

• Inquire about continuing involvement and contingencies

• Earned vs unearned

• Review major sales contracts

• Multi-deliverable contracts

Other relevant assertions to sales revenue?

• Completeness

• Valuation

• Presentation and Disclosure

How to test completeness in sales revenue?

• substantive analytical procedures

• cut-off testing

How to test valuation over sales revenue?

• Controls over pricing and the approval of price lists

• Detailed testing of sales prices in invoices

• Review sales contracts and revenue recognition policies

How to get evidence about presentation and disclosure for sales revenue?

• Revenue recognition policies (earned vs unearned)

• Customer concentration (reliance on major customers)

What are the most risky assertions over AR?

Existence, rights and obligations, and valuation

How to get evidence over existence and rights and obligations for AR?

• Internal controls over recording of sales, credit, shipping, billing, and receipts (same as sales revenue)

• Substantive test

Substantive testing for existence and rights and obligations of AR

• Confirm balance directly with customer (main source of evidence)

• Detailed testing of sales transactions (sales orders, sales invoices, shipping documents

• Review major sales contracts

How is detailed testing of sales transactions performed for existence and rights/obligations of AR?

• Similar test for sales revenue

• Vouch receivable to subsequent receipt of cash

How to think of the allowance around AR

Think of allowance as the account that ensures AR is property valued (AR, net on the balance sheet)

Other relevant assertions to accounts receivable?

Completeness and presentation

How to get evidence over completeness of AR?

• Internal controls over recording of sales, credit, billing, and receipts (same as revenue)

• Cut-off testing (same as revenue)

How to get evidence over presentation of AR?

• Review financial statements (credit policies)

• Allowance

What is the riskiest assertion over allowance?

Valuation

How to gather evidence over valuation of the allowance?

• Control testwork over credit approval process, credit monitoring, and the monitoring of receivables

• Substantive test

What are the three aspects of the substantive tests over valuation of the allowance account?

• Analytical Review

• Credit specialist review

• Test value of collateral or analyze whether recourse exists

Analytical review (very judgemental)

• Ratio Analysis

• Trend analysis

• Aging of receivables

• Historical repayment options

• Also forward-looking information (micro and macro economic conditions)

Credit Specialist Review

• Review credit quality of customers

• Review reserving percentages

Test value of collateral or analyze whether recourse exists

expected loss = probability of default * loss given default

Bad Debt Expense Formula

BDE = EB - BB + Write Offs

Control Testing in the Revenue Cycle

Building an understanding of a process is critical for identifying key controls to test and determining how to test them

Substantive Testing in the revenue cycle

• Gather evidence

• Evidence requires an “audit trail”

• To identify the audit trail, we need to understand the transaction cycle

• Must figure out how a company earns revenue and how it is recorded

How do we understand how a company earns revenue and how it is recorded?

• walkthroughs

What does business risk depend on?

How the business earns and records revenue

Questions to think about when assessing business risk

• How competitive is the industry?

• How fast paced is innovation

• What is the current customer base?

• What are other potential customers?

How competitive is the industry?

• Market share

• Margins

How fast paced is innovation?

• Revenue growth

• Revenue sustainability

What is the current customer base?

• Customer Concentration

• Stability of customers

What are other potential customers?

• Growth

• Replacing lost business

What must auditors presume about fraud risk?

Auditors must presume there is fraud risk involving improper revenue recognition

Examples of fraud involving improper revenue recognition

• Booking fictitious sales

• Artificially boosting current year revenue

• Lapping

• Recording gross vs net revenue

Substantive Testing Procedures for AR

• Confirmations

• Cutoff testing

Substantive testing procedures for revenue

• Substantive analytical procedures

• Test of details

• Cut-off testing

Substantive testing procedures for allowance

• Collectibility analysis

• Analytical review

• Engage a credit specialist

Conceptually, how does AI work?

input → black box → output

What happens inside the black box

• Fitting and re-fitting statistical models

  • minimizing error terms

  • maximizing explanatory power

• Detecting patterns in higher-order interaction (multiplication of variables)

Advanced technologies: where we’ve been

Computer assisted analytics

• Traditional mechanical scanning software (journal entries)

• Sampling routines

Advanced technologies: where we are

• Iconfirm and Icount

• Google Maps

• RPA (data scrubbing)

• Off the shelf programs

• Proprietary GPT systems

Advanced technology: where we are going

Cognitive technologies

What is the main issue with 100% testing?

It is a neat idea, but risky and hard to capture efficiencies

Three way match

customer order file + shipping document file + sales invoice file = match fields automatically, generate a file with exceptions

What do we learn from a three-way match?

• Not a known or likely difference

• Only an indication that there is a problem

• Tells us where to look further to determine if we need to identify an audit difference

Weakness of 100% testing with assertions

• We need to test data files for completness, existence, and accuracy - pervasive issues with D&A in auditing

• This is done by vouching data file to specific underlying transactions, which is essentially the same as doing the three-way match manually

Check Kiting

transferring funds from one bank account to another bank account just before year end in order to overstate cash

Where do auditors keep track of likely misstatements throughout an audit?

The summary of audit differences

What types of misstatements must be tracked on the SAD?

All misstatements greater than the clearly trivial threshold

What must happen to a misstatement greater than performance materiality?

It must be addressed individually

During the completion stage, how do auditors determine if the financial statements are misstated?

Aggregate the individually immaterial misstatements greater than the clearly trivial threshold

What must happen if all the likely misstatements between the clearly trivial and performance materiality aggregate to an amount greater than PM?

Auditor must require management to record adjustments until this is not the case

As long as all likely misstatements fit in the ___, we are okay

fridge

Become familiar with the math examples in lecture slides 9

Become familiar with the math examples in lecture slides 9

Contingencies examples

• Pending litigation

• Disputed tax deductions

• Warranties

• Allowance

When should a loss be recorded as a liability?

If loss is probable and reasonably estimable

When should a loss be merely disclosed in the notes to the FS?

When the loss is probable OR estimable

Procedures for Contingencies

• Inquire of management

• Read minutes

• Read contracts/agreements

• Read IRS correspondence

• Analyze legal expenses

What do we do if there are unrecorded liabilities for pending/threatened litigation or unasserted claims?

Get a legal letter

What does an attorney furnish in a legal letter?

• Description

• Update on progress

• Planned action

• Likelihood of favorable outcome

• Estimate (or range) of potential loss

Inherent Limitations of a legal letter

• NOT a confirmation

• Attorney client privilege

Attorney Client Privilege

Attorneys can only tell auditors what management tells them they can tell auditors

How can we trust that management has been fully forthcoming with the auditors?

The management representation letter

What key areas are addressed in a management representation letter?

• Financial statements in compliance with GAAP

• Completeness of information provided

• Recognition, measurement, subsequent events, disclosure

• Loss contingency, related party, etc disclosures

What happens if management won’t sign the rep letter?

Then the audit opinion will not be issued

When should the auditor get the rep letter?

Prior to signing the audit opinion

What is an implication of related party transactions?

They may not be at arm’s length and should be disclosed

Key question about related party transactions

Does the legal form match the economic substance? If not, FS users need to know this

What factors increase the risk that management will use RP transactions to manipulate earnings?

• Optimistic earnings forecast

• Declining industry

• Compensation

How should an auditor evaluate if a RP transaction’d disclosures are accurate?

Through understanding the purpose, nature, and extent of transactions and FS impact in order to evaluate whether the disclosures made by management are adequate

Where should auditors identify related party transactions?

• Inquiries of management

• Management rep letter

• Invoices from law firms

• Legal letters

• Loans receivable/payable confirmations

• SEC filings

• BOD minutes

• Conflict of interest statements/policies

Type 1 Subsequent Events

relate to conditions (ie material economic substance) existing on or before the balance sheet date

Type 2 Subsequent Events

Relate to conditions occuring after the balance sheet date

What is the procedure for type 1 subsequent events?

Adjust

What is the procedure for type 2 subsequent events?

Disclose

Where do auditors identify subsequent events?

• Inquire of management

• Obtain management rep letter

• Obtain legal letters

• Read BOD minutes from meetings after YE

• Read latest available FS and compare to FS being audited

• Scan general ledger

• Look for news in the press

Why are companies hesitant to disclose an actual amount for a subsequent event, particularly in litigation?

Due to self-fulfilling prophecy

Going Concern Assumption: Responsibility of management

• Assessing company’s going concern status for a reasonable period of time

• Reasonable period is one year

Going concern Assumption: responsibility of the auditor

• Use of bankruptcy prediction models to analyze whether a particular client may have a going-concern problem

• Auditor must disclose if they believe a company will not make it

What should the conclusion look like on the audit documentation?

Based on procedures performed, the account is complete, exists, etc

Auditor responsibilities after report issuance

• Subsequent discovery of facts

• Considering omitted procedures

Subsequent discovery of facts

• If new information surfaces, no obligation to perform post-issuance audit procedures

When should an auditor take action with subsequent discovery of facts?

• Information is reliable

• Facts existed at the audit report date

• If known, the report would have changed

• Outsiders are relying on FS

What action should be taken with subsequent discovery of facts?

• Advise client to issue restated financial statements

• If the client refuses, notify the SEC

Considering Omitted Procedures

Audit procedures were omitted or overlooked

What if audit procedures were omitted/overlooked?

• Consult an attorney

• Assess significance of the omitted procedure

• If misstatement found, treat it as subsequent discovery of facts

Audit Documentation Requirements

• Clear understanding of purpose

• NET of procedures performed

• Evidence obtained

• Conclusions reached

• Name of person who performed the work and date it was completed

• Name of person who reviewed the work and the date it was completed

• The documentation should be clearly organized to provide a link to the significant findings or issues

The elements of a workpaper

• Header with:

  • The client name

  • Workpaper title

  • Year-end date

• PBC if prepared by the client

• Purpose, procedures, and conclusion

• Preparer and reviewer signoffs

• The purpose stating what assertions are being tested