Exam 1 study guide ch1-5 PDF

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Chapter 1: Auditing and Assurance ServiceWhat is auditing?  Auditing is a systematic process of objectively obtaining and evaluating evidence regarding assertions about economics actions and events to ascertain the degree of correspondence between the assertion and established criteria and communic...

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Chapter 1: Auditing and Assurance Service What is auditing? 

Auditing is a systematic process of objectively obtaining and evaluating evidence regarding assertions about economics actions and events to ascertain the degree of correspondence between the assertion and established criteria and communicating the results to interested users.

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3 components: systematic process, evidence, assertions

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Purpose of auditing is providing financial statement users with an opinion on whether the financial statements are presented fairly in all material respects, in accordance with the applicable financial reporting framework

What are the relevant risks (e.g., Information Risk)? 

Business risk is the risk that an entity will fail to meet its business objectives. When assessing business risk, a professional must consider all possible threats to an entity’s goals and objectives. (Ex: competition, product line is obsolete, tax increase, government contract is lost, employees leave the entity)

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Information risk is the probability that the information circulated by a company will be false or misleading. Users demand an independent third-party assessment of the information.

What is the difference between Auditing, Attestation, and Assurance Services? 

Auditing is a process or examining and discovering financial records, date, risk, or compliance issue if they are accurate and applicable laws before audit took place.

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Attestation: evaluates and reviews how true the data or information is when compared to a stated purpose, internal control or system.

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Assurance: is an independent professional service that improves the quality of information or its context for decision makers.

Management Assertions: 

Existent or Occurrence: the detail in the general ledger relate to the transaction that have occurred to the entity. Assets and Liabilities included in the account exist and recorded transactions are valid and have actually occurred. (Ex: Management asserts that all revenue transactions recorded during period were valid transactions.)

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Rights and Obligations: the assertion about the right and obligation address whether the entity holds or controls the right to assets. Entity has legal claim on all assets, and revenues reported and has a legal responsibility for all liabilities and expenses. (Ex: Management asserts that entity has legal title or rights of ownership to inventory show on balance sheet)

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Completeness: whether all balances, events, and transactions have been recorded in the financial statements. (Ex: if client fail to record a valid revenue transaction, the account will be understated, Failure to meet completeness assertion result understatement in the relate account.

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Valuation or Allocation: whether assets, liabilities, and recorded transactions have been valued in accordance with GAAP. (Ex: management asserts that inventory is carried at the lower cost or market value on the balance sheet.

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Presentation or Disclosure: all accounts are presented in appropriate place and all information required has been disclosed in the statements and footnotes. (Ex: management asserts that financial statement properly classifies and present the inventory.)

Professional Skepticism 

Professional skepticism is an attitude that include questioning mind, being alert to conditions which many indicate possible misstatement due to error or fraud, and critical assessment of audit services. Essentially, it is an auditor’s responsibility to not accept management assertions without corroboration.

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(1) What do I need to know?

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(2) How well do I know it?

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(3) Does it make sense?

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(4) What can go wrong?

Must be skeptical because a potential conflict of interest always exists between the auditor and the client. o

Question mindset is a disposition to inquiry with some sense of doubt.

o

Suspension of judgement is withholding judgment until appropriate evidence is obtains.

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Search for knowledge desire to investigate beyond the obvious with a desire to corroborate.

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Interpersonal understanding recognizes that people’s motivations and perceptions can lead them to provide bias or misleading information.

o

Autonomy is the self-direction, moral independence, and conviction to decide for oneself rather than accepting the claim of others.

o

Self-esteem is the self-confidence to resist persuasions and to challenge assumption or conclusions.

Types of auditors (e.g., Internal vs. External) 

Internal auditors performed by members of the organization (some large hospitals have internal audit department) and are employees of individual companies, government agencies, other entities. (Ex: evaluate effective cost of company policy …)

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External auditors performed by an individual or group not a part of the organization of practice. Audit financial statements of publicly trade, municipalities, individuals … Conduct compliance, operational, and forensic audits. Must be a CPA. (Ex: assign to focus on assertions …)

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Government auditors employed by Fed, State, or local agencies. (Ex: determine whether goals providing = opportunities …)

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Forensic auditors employed by corporations, government agencies, public accounting firms … Trained in detecting, investigating, and deterring fraud and white-collar crime. (Ex: performance criteria …)

Chapter 2: Professional Standard Sarbanes-Oxley Act of 2002 

Sarbanes-Oxley Act of 2002 applies to all publicly held companies, trade companies and their audit firms introduced major changes to regulation of corporate government and financial practice. To protect investors by improving the accuracy and

reliability of corporate disclosures made pursuant to securities laws, and other purposes. (Main idea is a set of requirements for all public held company board, managements, and public accounting firms)

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Major changes as the result of SOX: o

The Act created the Public Company Accounting Oversight Board (PCAOB) to provide external and independent oversight over the audits of public entities.

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o

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Can issue standards & inspect registered accounting firms.

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Firms with > 100 public audits are inspected every year, all others every 3 years.

The Act built a stronger relationship between external audit and audit committee. -

External audit reports to audit committee (not mgmt.)

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Includes requirement of having 1 financial expert on the audit committee.

The Act increased penalties for destroying records, committing securities fraud & failing to report fraud. -

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Includes stronger protections for whistle-blowers.

Management must assess & make representations about the effectiveness of internal controls. -

Auditors must attest to managements representations. 

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Includes identifying significant deficiencies & material weaknesses.

Auditors must: -

Have 2nd partner review

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Rotate audit partners every 5 years

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Required cooling off period for company management

Sarbanes-Oxley Act of 2002 consist of 11 “Titles,” the first four of which are directly applicable to auditors. o

1) Public Company Accounting Oversight Board (PCAOB)

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2) Auditor independence

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3) Corporate Responsibility

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4) Enhanced financial disclosures

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5) Analyst conflicts of interest

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6) Commission resources and authority

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7) Studies and reports

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8)Corporate and criminal fraud accountability

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9)White collar crime penalty enhancement

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10) Corporate tax returns

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11) Corporate fraud accountability

Generally Accepted Auditing Standards 

GAAS are auditing standards that identify necessary qualifications and characteristics of auditors and guide the conduct of audit examination. Measure quality of performance.

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The purpose of GAAS is: o

To obtain reasonable assurance about whether the financial statements as whole are free of material misstatement, whether due to fraud or error.

o

To issue a report on the financial statements and communicate in accordance with auditor’s finding.

GAAS Fundamental Principles: (three majors) 

Responsibilities defines objectivity and identifies the important role that objectivity plays in the audit. o

Competence and capabilities, Training in auditing (How: education, experience …)

o

Ethical requirements, Independence and Due care -

Independence in fact is based on your actions in a situation or real independence. The ability to provide an opinion without being affected by influences that compromise professional judgment, to act integrity and to exercise objectively and professional skepticism.

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Independence appearance relates to other perceptions of auditor’s independence, is what a third parties would perceive as being independence so you are perceived by others to be independent.

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Due care is level of performance by reasonable auditor in similar circumstance. (what would another auditor do)

Professional skepticism and judgment -

Skepticism: an attitude that includes a questioning mind and a critical assessment of audit evidence.

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Judgment: application of training, knowledge, and experience in making informed decisions during audit.

Performance requires among other things and auditors to plan the work (i.e., conduct the audit using a “systematic process”) and to “obtain and evaluate evidence” through assessing the risk of material misstatement and gathering sufficient appropriate evidence. To obtain and provide reasonable assurances that financial statements do not contain material misstatements. o

Reasonable assurance recognizes that audit may not detect all material misstatements. Auditors should provide a high level of assurance or confidence regarding their work.

o

Planning and supervision are preparation of audit plan. List of the audit procedures that auditors need to perform to gather sufficient appropriate evidence on which to have their opinion on the financial statements.

o

Materials recognize that auditors should focus on matters that are important to financial statement users. (Ex: materiality as dollar, auditors and user do not expect account balances to be accurate to penny. Misstatement of $1,000 in $15 billion net income will not affect the decision, but misstatement of $1 billion will probably would.)

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Risk assessment requires an understanding of the client, its operating environment, and its industry. (including internal control)

o

Audit evidence requires that audit teams collect and evaluate sufficient appropriate evidence to provide a reasonable basis for their opinion. -

Sufficient = quantity (How many transactions or components?)

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Appropriate = quality (What level of reliability is needed? Source?) trustworthy (reliable), relevant (assertion of interest)

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Reporting provides guidance for “communicating the results” of the audit about whether the financial statements are prepared using “established criteria” (an applicable financial reporting framework, or GAAP). Express an opinion or state opinion cannot be expressed. Opinion is based on conformity of financial statements with applicable financial reporting framework . o

Conformity of engagement

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Conclusion about criteria

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Reservation

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Limitation (restrictions) on the report use

What are the 4 Main Types of Audit Opinions?

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Unqualified (Unmodified) o

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F/S are in conformity with GAAP

Qualified (Modified) o

Except for limited items, F/S are in conformity with GAAP

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Can issue for GAAP departure and scope limitation

Adverse o

F/S are not in conformity with GAAP

o

Can issue for GAAP departure (more serious)

Disclaimer o

Auditors do not express an opinion

o

Can issue for scope limitation (more serious) or situation in which auditor is not independent

Elements of a System of Quality Control 

Leadership responsibilities for quality within the firm (“tone at the top”) o

In order for quality control standards to be effective, it is important that the firm’s management take a lead role in clearly and consistently demonstrating its own commitment to quality control and high-quality work. Doing so will make it clear to all personnel that high-quality work is valued and will be rewarded.

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Relevant ethical requirements o

Firms should take various actions to ensure that personnel assigned to engagements are both independent in fact and independent in appearance with respect to the firm’s clients

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Acceptance and continuance of client relationships and specific engagements o

One of the most important decisions facing an audit firm is that of accepting an engagement (for a new client) or continuing to perform an engagement (for an existing client).

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Human resources o

The quality of any professional services organization (such as an audit firm) is based on the quality of its people. Effective quality control policies and procedures should be implemented to ensure that firms hire quality personnel ...

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Engagement performance o

Publish guidelines for review of each auditor's report including determination of the adequacy of evidence shown in the audit documentation, the conformity of the report with professional standards, and the review of the report.

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Monitoring

o

The purpose of monitoring is to provide the firm with reasonable assurance that policies and procedures composing the system of quality control are operating effectively and complied with in practice

Chapter 3: Engagement Planning Pre-Engagement Activities 

Pre-engagement activities are that auditors undertake before beginning an audit engagement. Public accounting firms try to reduce its business risk by carefully managing audit engagement. To do so, they undertake several activities (called risk management activities) before beginning an audit engagement.

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Client Acceptance or Continuance generally include: o

Obtain and Review of financials about client

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Background checks (criminal, previous auditors, senior managers …)

o

Other people, who do business with client (bankers, legal counsel …)

o

Consider if engagement will need special attention or involve unusual risks to firm

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Evaluate firm and client relation

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Considering the need of special field

Communication between predecessor and prospective auditors (expect to hear from new auditors) o

Communication the predecessor auditors gave the former client about fraud, illegal acts, internal control recommendation.

o

The predecessor auditor’s understanding about the reasons for the changes of auditors (particularly about the predecessor auditors’ termination)

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Client management integrity issue

Compliance with Independence and Ethical Requirements o

Auditors must maintain independence in mental attitude and independence in fact.

o

Independence in appearance relates to perceptions of auditors’ independence.

o

A lack of independence can result in disciplinary action by regulators and/or professional organizations and litigation by those who relied on the financial statements.

o

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Public accounting firms must have a process in place to ensure that they are independence of the company being audited.

Engagement Letters is that auditors reach a mutual understanding with clients concerning engagement requirements and expectations and to document this understanding, usually in the form of a written letter. o

When a new client is accepted or audit engagement continues from year to year, an engagement letter should be prepared.

o

Acts as a contract between auditor and client.

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Serve as means of reducing the risk of misunderstanding with the client and as a means of avoiding legal ability for claims that the auditors did not perfume the work promise.

o

This engagement letter sets forth the understanding with the client including: -

Objective of the management (scope and limitation)

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Management’s responsibilities

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Auditor’s responsibilities

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Any limitation of engagement

Termination Letter is documentation that provided to former clients dealing with subject of future services … o

Reduce the risk of misunderstandings with the client in other to avoid legal liability

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Termination letter are NOT required, but may be a good idea to reduce misunderstandings with clients

Audit Planning 

Audit plan is a comprehensive list of the specific audit procedures that the audit team needs to perform to gather sufficient appropriate evidence on which to base their opinion on the financial statements. The professional standards require that the auditor plan each audit engagement, including the establishment of an overall strategy for each audit engagement.

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When planning the engagement, the auditor needs to develop and document a plan the describes the procedures to be perform to assess the risk of material misstatement at financial statement and assertion level. The auditor must carefully plan the nature, timing, extent of control test and substantive tests that are designed to mitigate these risks to an acceptable level. o

Nature is what audit procedures will be performed.

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Timing is when audit procedures will be performed. (depends on size and complexity)

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Extent is how audit procedures will be performed. (effectiveness and efficiency …)

Materiality 

Misstatements or omission of an item in financial report is materiality if individual or aggregate, they are reasonably expected to influence the economic decision of users of financial statements. o

Quantitative is as dollar magnitude of mi...