ACCT 4400 exam 2

Management Assertions

represent management's claims about recognition, measurement, presentation, and disclosure in the financial statements.

three categories of management assertions

balance assertions, transaction assertions, presentation & disclosure

Balance assertions (Balance Sheet accounts)

Rights and Obligations, Existence, Completeness, Valuation.

Transaction assertions (Income Statement accounts)

Occurrence, Completeness, Accuracy, Classification, Cutoff.

Presentation & Disclosure assertions

Rights/Obligations/Occurrence, Completeness, Accuracy, Classification, Understandability.

for Revenue, the key transaction assertions are

Cutoff, Occurrence, and Accuracy (overstatement risk)

for Expenses, the key assertions are

Cutoff, Completeness, and Classification (understatement risk).

Directional Testing

vouching, tracing

Vouching

Tests existence or occurrence by moving from the ledger to source documents.

Tracing

Tests completeness by moving from source documents to the ledger.

Audit Evidence Characteristics

sufficiency, appropriateness, most reliable, moderately reliable, least reliable

Sufficiency

The quantity of evidence - more is needed when there is higher risk of material misstatement, less reliable evidence, or less effective controls.

Appropriateness

The quality of evidence - made up of relevance (relates to the assertion being tested) and reliability (depends on the source: third-party/external evidence and originals are more reliable than client-prepared or copied documents).

Most reliable audit evidence

Auditor's direct knowledge and external confirmations.

Moderately reliable audit evidence

External documents maintained by the client.

Least reliable audit evidence

Internal documents and verbal inquiry.

Audit Procedures & Types of Substantive Tests

reperformance, inspection of tangible assets, inspection of records/document, substantive analytical procedures, tests of details

Reperformance

The auditor independently executes the control or procedure (the strongest evidence).

Inspection of Tangible Assets

Tests existence and valuation, but not rights and obligations.

Inspection of Records/Documents

Includes vouching (existence) and tracing (completeness).

Substantive Analytical Procedures

Evaluate plausible relationships among financial and non-financial data.

Tests of Details

Directly test account balances or transactions for monetary misstatement.

The Audit Program

The detailed listing of audit procedures to be performed during the engagement.

Permanent Files

Long-term information such as contracts and debt agreements that remain relevant across audits.

Documentation Retention

PCAOB standards require audit documentation to be retained for 7 years after completion of the audit.

Auditor's responsibility

Auditors are responsible for identifying material direct-effect illegal acts.

Management responsibility

is responsible for designing, implementing, and maintaining internal controls.

Auditors of public companies responsibility

must issue an opinion on internal control effectiveness under SOX 404b.

COSO Objectives (3)

Reliability of financial reporting, operational effectiveness and efficiency, and compliance with applicable laws and regulations.

COSO Components (5)

Control Environment ("tone at the top"),

Risk Assessment (identifying/assessing risks to objectives),

Control Activities (policies and procedures),

Information and Communication (relevant information sharing),

Monitoring Activities (evaluating the effectiveness of controls).

COSO Transaction-level assertions tested for controls

Occurrence, Completeness, Authorization, Accuracy, Cutoff, Classification.

Audit Strategies

reliance and substantive

Reliance Strategy

Auditor plans to rely on controls (control risk assessed below maximum) and must test their effectiveness - more control testing, less substantive testing.

Substantive Strategy

Used when controls are weak or inefficient to test; control risk is set to maximum, so only substantive work is performed.

Audit strategy Sequence

obtain an understanding of controls → perform tests of controls → finalize the assessed level of control risk → design substantive tests.

Procedures for testing controls, from least to most assurance

inquiry (low) < observation (low) < inspection of documents < reperformance (best).

Internal Control Deficiencies

control deficiency, significant deficiency, material weakness

Internal Control Opinions

unqualified (ICFR), adverse (ICFR), disclaimer (ICFR)

Control Deficiency

A control does not prevent or detect a misstatement in a timely manner.

Significant Deficiency vs. Material Weakness

severity depends on (1) the likelihood the deficiency will fail to prevent/detect a misstatement, and (

Unqualified (on ICFR)

No material weaknesses identified.

Adverse (on ICFR)

One or more material weaknesses exist.

Disclaimer (on ICFR)

A severe scope limitation prevents testing.

Sampling

applying audit procedures to less than 100 percent of items in a population to draw a conclusion about the whole population.

Sampling Risk

the risk that the sample doesn't represent the population, so the auditor's conclusion differs from what examining the entire population would show.

Nonsampling Risk

risk from auditor error (e.g., failing to recognize a misstatement, applying an inappropriate procedure) - not reduced by a larger sample.

Types of Statistical Sampling

attributes sampling, classical variables sampling, monetary unit sampling (MUS)

Attributes Sampling

Estimates the proportion of a population with a binary (yes/no) characteristic (e.g., "was this properly approved?") - used for tests of controls.

Classical Variables Sampling

Estimates a numerical/dollar amount (e.g., is an account materially misstated?) - used for substantive tests.

Monetary Unit Sampling (MUS)

Uses attributes-sampling theory applied to dollars - the sampling unit is the individual dollar, which increases the probability of selecting higher-value items; increases the likelihood of detecting overstatements.

Attributes sampling

Risk of Assessing Control Risk Too Low (an effectiveness loss - the auditor under-tests and may miss a material misstatement) vs. Risk of Assessing Control Risk Too High (an efficiency loss - the auditor does unnecessary work).

Variables/substantive sampling

Risk of Incorrect Acceptance (an effectiveness loss - concluding a balance is fairly stated when it is materially misstated) vs. Risk of Incorrect Rejection (an efficiency loss - concluding a balance is misstated when it is not).

Auditors are more concerned with the effectiveness losses (Assessing Control Risk Too Low / Incorrect Acceptance) since…

these can lead to an inappropriate audit opinion; it is generally preferable to accept the efficiency-loss error over the effectiveness-loss error.

Determinants of Sample Size

confidence level, tolerable error, expected error, population size

Confidence Level

higher desired confidence → larger sample.

Tolerable Error/Deviation Rate

higher tolerable error → smaller sample.

Expected Error/Deviation Rate

higher expected error (linked to higher IR/CR) → larger sample.

Population Size

has a relatively small effect on sample size for large populations.

Sample Selection Methods

random selection, systematic selection, haphazard selection, block selection

Random Selection

matching items to a series of randomly generated numbers.

Systematic Selection

a random starting point, then selecting every nth item (limitation: can bypass items with similar characteristics if the population has a pattern).

Haphazard Selection

a nonsystematic, non-random selection.

Block Selection

a series of contiguous items selected together.

Monetary Unit Sampling / Key Terms

sampling unit, precision, confidence

The sampling unit is the

individual dollar, increasing selection probability of higher-value items.

Precision

the numeric distance from the sample estimate within which the true population value is likely to lie.

Confidence

the likelihood that the precision interval actually contains the true population value.

Revenue Recognition (ASC 606) - 5 Steps

a) Identify the contract with the customer,

b) Identify the performance obligations (distinct promises) in the contract,

c) Determine the transaction price,

d) Allocate the transaction price to the performance obligations,

e) Recognize revenue when (or as) each performance obligation is satisfied.

Fraud Risks

channel stuffing, side agreements, bill-and-hold arrangements, fictitious sales, kiting

Channel stuffing

Shipping excessive inventory to inflate sales.

Kiting

where someone exploits the "float" time—the delay between when a check is deposited and when it actually clears; using non-sufficient funds checks between two or more bank accounts, a perpetrator falsely inflates their account

Side agreements

Altering terms to induce customers to accept shipments.

common revenue fraud schemes

Bill-and-hold arrangements (inventory parking) and fictitious sales

Revenue is the most frequently…

misstated account in financial statement fraud, so risk assessments for revenue are generally high.

Revenue Assertions Tested

occurence, completeness, authorization, accuracy, cutoff, and classification & presentation

Occurrence

Vouching from journal to supporting documents (shipping documents, customer orders).

Completeness

Reviewing the numerical sequence of shipping documents/invoices to ensure nothing is left unrecorded.

Authorization

Verifying approval of transactions (e.g., credit approval for sales).

Accuracy

Verifying revenue transactions are recorded at the correct amounts.

Cutoff

Matching shipping document dates with recorded sales dates.

Classification and Presentation

Transactions recorded in the correct accounts and properly presented/disclosed.

A/R Positive Confirmation

The customer is asked to respond either way (whether the balance is correct or not) - used when risk is higher or account balances are large; nonresponses require follow-up or alternative procedures.

A/R Negative Confirmation

The customer is asked to respond only if they disagree with the balance - appropriate when risk is low, controls are strong, and there are many small customer balances; unreturned negative confirmations provide little assurance.

Confirmations primarily provide evidence of…

Existence (and, to a lesser extent, valuation/accuracy)

Confirmations are not strong evidence for…

Completeness, since customers are unlikely to report an understated balance in their favor.

Substantive Analytical Procedures

horizontal analysis, vertical analysis, trend analysis, reasonableness tests

Horizontal Analysis

Comparing financial statement numbers/ratios across several years.

Vertical Analysis

Expressing balance sheet accounts as a percentage of total assets (or income statement accounts as a percentage of revenue).

Trend Analysis

Comparing current-period results to several prior periods.

Reasonableness Tests

Using non-financial data (e.g., number of units, average price) to develop an independent expectation for an account balance.

Auditing Cash Key Concepts

imprest account, cash equivalents

Imprest Account

An account used for a specific, limited purpose, such as payroll.

Cash Equivalents

Short-term, highly liquid investments with insignificant risk of changes in value.

As the volume of cash transactions increases…

inherent risk increases.

Key Controls example

Independent preparation of monthly bank reconciliations.

Fraud procedure: Kiting are detected by using…

an interbank transfer schedule.

Fraud procedure: Bank confirmations verify existence of…

cash balances.