Exam 2 

Chapter 6:

• Explain objectives of conducting and audit of financial statements and audit of internal controls

  • audit objective: provide financial statement users with an opinion by the auditor on whether the financial statements are presented fairly, in all material respects, in accordance with appropriate framework, which enhances the degree of confidence that users can place in the financial statements

  • internal control objective: to make sure that the the controls in place are designed to keep things in order and to detect or prevent fraud and error

• Differentiate between management’s responsibilities for the financial statements from the auditor’s responsibilities for verifying those statements

  • management responsibility for financial statements: adopting sound accounting policies, maintaining adequate internal controls, and making fair representations in the financial statements; extensive knowledge about the company transactions and related assets and accounts; integrity and fairness lies with the privilege of determining which presentations and disclosures considers necessary

  • auditor responsibility for financial statements: determining if financial statement disclosures are unacceptable, auditor issues adverse or qualified or drops out of engagement; makes sure they are compliant with rules and regulations

• Describe auditor’s responsibility for discovering material misstatements (due to fraud or error)

  • auditors responsibilities for material misstatements: according to aicpa standards, auditor must obtain reasonable assurance that statements are free from material misstaments, enabling the auditor to express an opinion, and report on statements and communicate findings based on auditing standards

  • material misstatements: If combined uncorrected errors and fraud would change or inflience the decisions of a reasonable person; calculated on a materiality threshold

  • reasonable assurance: evidence taken from testing a sample of a population, evaluating complex estimates and detecting fraud from collusions is difficult

  • material errors: most of the time is spend on detecting miscalculations, omissions, misunderstandings and misapplication of standards

  • auditors responsibility for material fraud: fraud is harder to detect because they are actively trying to hid it

• Explain professional skepticism and describe why it is so important when conducting an audit

  • professional skepticism: two primary components, a questioning minds and critical assessment of the audit evidence; trust but verify, suspension of judgement, search for knowledge, interpersonal understanding, autonomy, self esteem

• Describe key elements of an effective professional judgement process

  • professional judgement process: Identify and define the issue, gather facts and information and Identify relevant literature, perform analysis and identify alternatives, make the decision, review and complete the documentation and rationale for the conclusion

• Explain common judgement tendencies and strategies to mitigate them

  • confirmation: tendency to put more weight on information that is consistent with initial preferences; make the opposing case and consider alternative explanations; consider potentially disconfirming or conflicting information

  • overconfidence: tendency to overestimate one’s own abilities to perform tasks or to make accurate assessments of risks or other judgements and decisions; challenges opinions and experts, challenge underlying assumptions

  • anchoring: tendency to make assessments by starting from an initial value and then adjusting insufficiently away from that initial value; solicit input from others, consider management bias, including the potential for fraud or material misstatements

  • availability: tendency to consider information that is easily accessible as being more likely or more relevant; consider why something comes to mind, obtain and consider objective data, consult with others and make the opposing case

• Describe the different cycles within an audit

  • Sales and collection; acquisition and payment; payroll and personnel; inventory and warehousing; capital acquisition and repayment

  • sales and collection: sales journal, cash receipts journal, general journal, cash in bank, trade accounts receiveable, other accounts receivable, allowance for uncollectible accounts, saIes, sales returns and allowances, bad debt expense

  • acquisition and payment: acquisitions journal, cash disbersments journal, general journal, cash In bank, inventories, prepaid expense, land, builidngs, equipment, furniture, accumuleted depreciation, trade accounts payable, accrued payables, income tax, deferred tax, advertising, travel, sales meetings and traindings, promotional expenses, miscellaneuos sales expense, travel, supplies, postage, telecommunications, depreciation, rent, legal fees, auditing fees, insurance, repairs, office expense, miscellaneous general expense, gain on sales, income tax

  • payroll and personell: payroll journal, general journal, cash in bank, accrued payroll, accrued payroll taxes, salaries and commisions, sales payroll taxes, executive and office salaries, administrative payroll taxes

  • inventory and warehousing: acquisitions journal, sales journal, general journal, inventories, cost of goods sold

  • capital acquisitions and repayment: acquisitions journal, cash disbursements journal, general journal, cash in bank, notes payable, long term notes payable, accrued interest, capital stock, capital in excess of par value, retained earnings, dividends, dividends payable, interest expense

• Explain the benefits of a cycle approach to segmenting an audit

  • segmented audit: keeps the cycles apart and makes it easier to follow along the cycle and check over each account, way to organize the audit and keep things clean

• Describe why the auditor obtains assurance by auditing transactions and ending balances including presentation and disclosure

  • transaction related audit objectives: objectives that must be met in terms of the transactions

  • balance related audit objectives: objectives that must be met in terms of the account balances

• Describe managements assertions about financial information

  • Existence or Occurrence: assest or liabilites of the public company exist at a given date, recorded transacitons have occurred during the period

  • Completeness: all transactions and accounts that should be presented in the financial statements are also included

  • Valuation or Allocation: assets, liabilities, equity, revenue, and expense components have been Included in the financial statements at appropriate amounts

  • Rights and Obligations: the public company holds or controls rights to the assets, and liabillies are obligations of teh company at a given date

  • Presentation and Disclosure: the components of the financial statements are properly classified, described, and disclosed

• Apply transaction-related audit objectives to management assertions (above)

• Apply balance-related audit objectives to management assertions (above)

• Explain the relationship between audit objectives and accumulation of audit evidence

  • audit objectives and evidence: the audit objectives determines the amount of evidence needed to perform the audit

Chapter 7:

• Contrast audit evidence with evidence used by other professions

  • use of evidence: effects of medicine, guilt or innocence of accused, fairly presented financial statements

  • nature of evidence used: results of experiments, evidence and testimony by witnesses, evidence gathered by auditor third party and client

  • party evaluating evidence: scientist, jury and judge, auditor

  • certainty of conclusions: vary from uncertain to near certain, requires guilt beyond reasonable doubt, high level of assurance

  • nature of conclusions: recommend or not recommend medicine, innocence or guilt of party, issue one of several alternate audit reports

  • typical consequence of incorrect conclusions from evidence: distribution of ineffective or harmful medicine, guilty party is not penalized or innocent party is found guilty, statement users make incorrect decisions and auditor may be sued

• Identify and explain four audit evidence decisions that are needed to create an audit program

  • audit procedure: detailed instruction that explains the evidence to be obtained during the audit

  • sample size: size of data that is being analyzed for procedure, varies from one to all

  • items to select: must decide which items in the population to test

  • timing: determines when the audit needs to be completed based on the time in the accounting period

  • audit program: Audit procedures; sample size; items to select; timing

• Describe characteristics that determine persuasiveness of evidence

  • persuasiveness of evidence: the degree to which the auditor is convinced that the evidence supports the audit opinion, the two determinants of persuasiveness are the appropriateness and sufficiency of evidence

  • appropriateness of evidence: measure of the quality of evidence, meaning its relevance and reliability in meeting audit objectives for transactions

• Identify and apply the 8 types of evidence used in auditing

  • physical examination: Inspection or count by auditor of a tangible asset

  • confirmation: the receipt of a direct written response from a third party verifying the information

  • inspection: auditors examination of clients documents and records to substantiate teh information that is or should be included in financial statements

  • analytical procedures: evaluations of financial statements through analysis of plausible relationships among both financial and non-financial data

  • inquiry: obtaining written or oral information from the client in response to questions from the auditor

  • recalculation: Involves rechecking a sample of calculations make by the client

  • reperformance: auditors independent tests of client accounting procedures or controls that were originally done as part of teh entitiy accounting and internal control system

  • observation: consists of looking at a process or procedure being done or performed by others

• Explain and apply analytical procedures and their purposes

  • analytical procedures: required during in the planning phase, done during the testing phase of the audit as substantial test in support of account balances, also required during the completion phase of the audit; industry data, similar prior period data, client determined expected results, auditor determined expected results

• Explain how auditors incorporate data analytics and other advanced technologies in an audit

  • audit data analytics: allows auditors to obtain and evaluate audit evidence

  • artificial intelligence: computers performing routine repetitive processes and learn patterns

  • robotics: manufacturing uses robotics to streamline many processes

• Explain and compute common financial ratios

  • cash ratio: cash + marketable securities / current liabilities

  • quick ratio: cash + marketable securities + net accounts receiveable / current liabilities

  • current ratio: current assets/ current liabilities

  • act rec. turnover: net sales / average gross receivables

  • days to collect receive. : 365 / act rec turn

  • inventory turnover: cogs / avg inventory

  • days to sell inventory: 365 / inventory turnover

  • debt to equity: total liabilities / total equity

  • times interest earned: operating income / interest expense

  • eps: net income / avg. com. shares outstanding

  • gross profit percent: net sales - cogs / net sales

  • profit margin: operating income / net sales

  • return on assets: Income before taxes / avg total assets

  • return on common equity: Income before tax - pref dividends / avg. stockholders

• Describe the purposes of audit documentation

  • purpose of audit documentation: aid the auditor in providing reasonable assurance that an adequate audit was conducted in accordance with standards

• Prepare organized audit documentation

  • organized audit documentation: client name, period covered, description, preparer, date, index code, cross referenced, state the work performed, tick marks, fufill objectives, plainly stated conclusion

Chapter 8:

• Explain why adequate audit planning is essential

  • essential audit planning: to enable auditor to obtain sufficient appropriate evidence for the circumstances, to help keep costs reasonable, and to avoid misunderstandings with the client

• Describe the process of making client acceptance decisions and perform initial audit planning

  • initial audit planning: Involves 4 things, to be done early in audit; accept new client or keep existing, the need for the audit, terms of engagement, overall strategy

  • client acceptance: taking on a new one or keeping existing, new client investigation, required by standards to communicate with the predecessor auditor,

• Explain why gaining an understanding of the client’s business and industry is important

  • understanding industry: economic conditions, information technology, globally expanded companies, human capital and other intangible assets, complex financial instruments specific to industries; risks associated with specific industries, industries have different accounting standards and procedures

• Explain and perform preliminary analytical procedures

  • preliminary analytical procedures: common size income statements and balance sheets

• Explain and apply the concept of materiality to an audit

  • materiality to an audit: the magnitude of misstatments that individually, or when agrregated with other misstatements could be expected to influence economic decisions of users

  • performance materiality: materiality for segments of the audit - classes of transactions, account balances and related disclosures

• Make preliminary judgements about what amounts to consider material

  • preliminary judgements about materiality: maximum amount by which auditor believes statements could be misstated and not affect the decisions of reasonable users; materiality is relative rather than an absolute concept; need to benchmark

• Explain and determine performance materiality during audit planning

  • performance materiality during audit planning: cannot exceed 60 percent of preliminary judgement

• Use materiality to evaluate audit findings

Chapter 9:

• Define risk in auditing

  • audit risk: the acceptance by auditors that there is some level of uncertainty in performing the audit function

• Explain the different types of risk assessment procedures

  • inquries of management and others within the entity: asking around for more information within the company in different departments

  • analytical procedures: helps to better understand the entity and to assess client business risks, identify unusual amounts, ratios or trends

  • observation and inspection: looking through the information to get better understanding

  • discussion among engagement team members: getting more angles at the information to see what other people see

  • other risk assessment procedures: asking around, getting more info from predecessor and outsiders

• Describe auditor considerations related to the risk of material misstatement due to fraud

  • risk of material misstatement due to fraud: the risk of not detecting a material misstatement due to fraud is higher than the risk of not detecting a misstatement due to error

  • auditors consideration of risk: made at both financial statement level and at the assertion level for classes of transactions and account balances, including disclosures

• Explain the auditor’s responsibility to identify significant risks

  • significant risk: an identified and assessed risk of material misstatement that, in the auditors professional judgement, requires special audit consideration

  • non-routine transactions: transactions that are unusual, due to size or nature, and that are infrequent in occurrence

  • matters that require significant judgement: development of accounting estimates for which measurement uncertainty exists; classes of transactions or account balances that are based on the development of accounting estimates often require significant judgement that is subjective or complex because it is based on assumptions about future events

• Describe and apply the audit risk model and its’ components

  • audit risk model: a formal model reflecting the relationships between AAR, IR, CR, PDR

  • audit risk model equation: AAR / IR * CR

  • acceptable audit risk: the acceptable risk that the given opinion may be wrong (auditor controls)

  • inherent risk: susceptibility of an assertion to material misstatement; risk associated with the business itself (auditor can only assess) (inversely related to PDR)

  • control risk: risk that the companies internal controls will detect or prevent misstatements (auditor can only assess)

  • planned detection risk: the risk that enough evidence will be collected and evaluated for the audit (auditor controls) (dependent on AAR, IR, and CR)

• Assess acceptable audit risk in various scenarios

  • engagement risk: Is the risk that the auditor or audit firm will suffer harm after the audit is finished, even though the audit report was correct, closely related to client business risk

  • external users’ reliance on financial statements: examine the financial statements, footnotes, and 10-K, reading minutes of BOD meetings, reading financial analysts reports for a publically held company, discuss financing plans with management

  • likelihood of financial difficulties: analyse the financial statements for financial difficulties using ratios and other analytical procedures, examine historical and projected cash flow statements for the nature of cash inflows and outflows

  • management integrity: follow the procedures discussed in chapter 8 for client acceptance and continuance

• Describe impact of various factors on the assessment of inherent risk

  • factors affecting inherent risk: nature of the clients business, results of previous audits, initial vs repeat engagement, related parties, complex or nonroutine transactions, judgement required to correctly record account balances and transactions, makeup of the population, factors related to fraudulent financial reporting, factors related to misappropriation of assets

  • making inherent risk decisions: must evaluate the information affecting inherent risk to assess the risk of material misstatements at teh audit objective level for cycles, balances, and related disclosures

• Describe the relationship of risk and audit evidence

  • relationship between AAR and evidence: reliance by external users, likelihood of financial failure, integrity of the management

  • AAR and evidence: Inversely related

  • relationship between IR and evidence: nature of the clients business, results of previous audits, initial vs repeat engagement, related parties, complex or nonroutine transactions, judgement required to correctly record account balances and transactions, makeup of the population, factors related to fraudulent financial reporting, factors related to misappropriation of assets

  • IR and evidence: directly related

  • relationship between CR and evidence: effectiveness of internal controls, planned reliance

  • CR and evidence: directly related

• Describe how materiality and risk are related and integrated into the audit process

  • materiality and risk: performance materiality depends on the nature of the account and how material it is to the financial statements as a whole