Acct 4200--Wilson Exam #1 Short Answers
Terms in this set (15)
Give a brief history of assurance (what caused the need and why) and explain how it plays a key role in today's society.
The development of the corporate form of business (mainly from the industrial revolution) and the expanding world economy over the last 200 years have given rise to an explosion in demand for assurance provided by auditors. Also demanded because it plays a valuable role in monitoring the contractual relationships between the entity, its stockholders, managers, employees, etc.
Securities Acts of 1933 and 1934 required audits for publicly traded companies, though most publicly traded companies had auditors in place before that. Agent (Company) will hire auditor to report on the fairness of their financial reports to reduce principal's (absentee stockholder's) information risk. Auditor will issue audit opinion to accompany company financials which adds credibility to the reports. INFORMATION ASSYMETRY
Identify and define the assertions about account balances at period end. Give an example of each.
Existence: assets, liabilities, and equity interests exist. An example would be inventory.
Rights and obligations: The entity holds or controls the rights to assets, and liabilities are the obligations of the entity. Example would be inventory held on consignment.
Completeness: All assets, liabilities and equity interests should have been recorded have been recorded. An example would be All inventory units that should have been recorded have been recognized in the financial statements. Any inventory held by a third party on behalf of the audit entity has been included in the inventory balance.
Valuation and allocation: assets, liabilities, and equity interests are included in the financial statements at appropriate amount and any resulting valuation or allocation adjustments are appropriately presented and described, and disclosures are clearly expressed. An example would be Inventory has been brought to the lower of cost or market with appropriate disclosure.
Describe the differences between auditing, attest, and assurance. Give an example of each.
Auditing: systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between those assertions and established criteria and communicating the results to interested users. ex: financial statement audits.
Attest: occur when a practitioner is engaged to issue... a report on subject matter, or an assertion about subject matter, that is the responsibility of another party.
**this is broader than auditing definition because attest services are NOT limited to economic events or actions. The subject matter of attest services can take many forms.
ex: prospective information, analyses, systems and processes and even the actions of specified parties.
Assurance: independent auditing services that improve the quality of information, or its context, for decision makers.
**Expanding auditor's activities to assurance services allows for reporting not only on the reliability and credibility of information but also on the RELEVANCE and TIMELINESS of the information. Assurance can include almost any service provided by accounting professionals that involves capturing information, improving its quality or enhancing its usefulness for decision makers.
ex: internal auditors
Identify and discuss society's expectations of an auditor and the auditor's responsibilities.
Society's expectation of an auditor is that he or she confirms every amount on the financial statements and obtains absolute assurance of the accuracy of the financial statements. Society expects each transaction to be verified and confirmed for accuracy. However, in reality, an auditor's responsibility is to make sure that the financial statements have been FAIRLY stated (obtain reasonable assurance). Auditor's look for material misstatements. If something is immaterial it is still "inaccurate", however it does not affect an investor's decision on the company.
Define corporate governance, the board of directors, and the audit committee and explain how they relate to each other.
Corporate governance: is the oversight in place to help insure the proper stewardship over an entity's assets. These are set by the Board of Directors. that is made up of people who are representatives of the shareholders and are they to make sure their best interest are kept in mind. In order to do so, the board of directors has a sub-group known as the Audit Committee. The audit committee is made up of 5 to 7 directors who are independent from management and have the responsibility of hiring and overseeing the internal and external auditors.
Identify and describe the 10 Generally Accepted Auditing Standards outlined by the PCAOB. Give examples of each
Adequate technical training & Proficiency-- formal education, continuing education programs.
Independence- maintain an attitude of independence. An auditor must not only be independent but also avoid relationships/actions that may appear to affect independence.
Due professional care- means that the auditor plans and performs their duties with the skill and care that is commonly expected of accounting professionals.
Standards of Field Work:
Adequate Planning & Supervised Assistants-- Proper planning leads to a more effective audit that is more likely to detect material misstatements. Standard also requires that assistants on engagements be properly supervised.
Obtain Sufficient Understanding of Internal Controls-- required understanding of internal controls to effectively plan the nature, timing, and extent of future audit procedures.
Obtain Sufficient Appropriate Evidential Matter-- enough credible evidence must be collected to afford a reasonable basis for an opinion regarding the financial statement under audit.
Standards of Reporting:
GAAP--report shall state whether financials are reported according to GAAP.
Consistency-- report shall identify those circumstances in which such principles have not been consistently observed in the current period in relation to the preceding period.
Disclosures-- disclosures on financials regarded as reasonably accurate unless otherwise stated in the report.
Opinion-- report shall contain an expression of opinion. If opinion is not possible, the report should state the reasons why. Also needs to say the degree of responsibility the auditor is taking and the character of the auditor's work.
Identify the three broad categories of factors considered when evaluating the reliability of the internal audit function. Identify two factors within each category. Give examples of each factor and explain how it would affect your decision to use the internal audit function.
1.) Whether the audit committee oversees employment decisions related to the Internal Audit Function (IAF).
2.) Whether the IAF is free of any conflicting responsibilities (ex: having other managerial or operational duties outside of the IAF).
1.)Whether the IAF is adequately and appropriately resourced relative to the size of the entity and nature of its operations.
2.)Whether established hiring, training, and assignment policies exist with internal audit engagements
Systematic and Disciplined Approach:
1.)The existence, adequacy, and use of documented internal audit procedures covering such areas as risk assessments, documentation, and reporting, etc. is commensurate with the size and circumstances of an entity.
2.)Whether the IAF has appropriate quality control policies and procedures set by relevant professional bodies for internal auditors.
Identify five additional steps to consider when planning an audit and give examples of how each would affect the audit.
1.Assess business risks: understand the entity's business and transactions and identify financial statement accounts likely to contain errors. By doing this, the auditor can allocate more resources to investigate more risky accounts. ex: bar. understand the industry to know what accounts to test more. maybe test cash mainly because of possible theft.
2.Establish materiality: establish tolerable misstatement for accounts AND disclosures. ex: the bar could have higher risk for cash account and therefore lower materiality and higher sampling size.
3.Consider multilocations: The auditor correlates the amount of audit attention devoted to the location or business unit with the level of risk present. ex: chain of bars, the bar that is the highest risk will have a higher level of audit attention than a lower risk bar.
Assess the need for specialists:
*sometimes an audit might require the need for a specialist to make sure that the auditor obtains reasonable assurance in an audit. Ex: the use of an IT specialist in the case of the presence of complex information technology. Another ex: client is a jeweler and need a professional to value the diamonds correctly.
5.***Consider violations of laws and regulations: Direct and Material: consider laws and regulations as part of the audit. Material and Indirect: be aware of what may have occurred, investigate if brought to attention. ex: tax laws and regulations that may affect the amount of revenue recognized under a government contract in a material way.
6.***Identify related parties: all transactions must occur an "arm's length" or be disclosed if a related party transaction occurred. Auditor needs to inquire of management about the names of related parties, nature of the relationships, and the types of transactions and reasons for them. How to identify: review board minutes, review conflict of interest statements, contracts, review significant unusual transactions, etc. Ex: transactions with immediate families of the principal owners and management need to be identified and investigated.
7.***Consider additional value-added services: Auditors who audit public companies are limited in the types of consulting services that they can offer their auditees. But, as part of the planning process, the auditor should look for opportunities to recommend additional value-added services. Ex: tax planning, system design and integration, risk assessment, benchmarking, etc.
8. ***Document the overall audit strategy, audit plan, and prepare audit programs: this involves documenting the decisions about nature, timing, and extent of the audit tests. At this stage, auditor compiles their knowledge about the entity's business objectives, strategies, and related business and audit risks and records how the entity is managing these risks and documents the effect these risks and internal controls have on the planned audit procedures. The auditor's preliminary decision concerning control risk determines the level of control testing, which in turn affects the auditor's substantive tests of the account balances and transactions. EX; documentation of all risks and overall effect on the audit plan.
Explain the difference between overall materiality and tolerable misstatement. Be able to draw a conclusion as to the overall fairness of the financial statements given a set of identified misstatements.
Overall materiality is the maximum amount by which the auditor believes the financial statements could be misstated and still not affect the decisions of users. The relative size of the company being audited affects overall materiality. Public companies typically use 2%-5% of net income before taxes as a benchmark. This is NOT a perfect method, however. Tolerable Misstatement is the amount of planning materiality allocated to an account or class of transactions. Combined tolerable misstatement will generally be greater than planning materiality because: not all accounts will be misstated by their full tolerable misstatement allocation, etc. Overall materiality will serve as a "safety net" so that if individual unadjusted misstatements that are less than tolerable misstatement aggregate to a total more than overall materiality, the auditor will have to perform more testing for proper assurance, adjustments to financials will need to be made, or a qualified or adverse opinion will need to be issued.
When the aggregated misstatements are less than the overall materiality, the auditor can conclude that the financials are fairly represented. The purpose of setting tolerable misstatement is to establish a scope for the audit procedures for the individual account balances or disclosures. Usually set tolerable misstatement for each account at 50%-75% of overall materiality.
Stacey, the partner in charge of the audit of RIF Enterprises, sets the planned level of audit risk for the audit of accounts payable at .06. The risk of material misstatement is assessed at .65. What is the detection risk for this audit?
Audit Risk = risk of material misstatement (Inherent Risk x Control Risk) x Detection Risk
=.0923 or 9.23%
Using the audit risk model, identify the relationship between the following elements. For each of the items below, highlight whether the two elements have an inverse relationship, a direct relationship, or no relationship. When considering each item, assume that the other components of the risk model remain constant. CHECK ON THIS!
a.) Engagement Risk and Acceptable Audit Risk
b.) Risk of material misstatement and detection risk
c.) Materiality and amount of substantive audit evidence
d.) Engagement risk and desired level of assurance
e.) Materiality and sample size
a. Engagement risk and acceptable audit risk: No Relationship. (engagement risk cannot be directly controlled by the auditor) CHECK ON THIS
b. Risk of material misstatement and detection risk: Inverse Relationship
c. Materiality and amount of substantive audit evidence: Inverse Relationship.
d. Engagement risk and desired level of assurance: No Relationship. (for same reason as a).
e. Materiality and sample size: Inverse Relationship.
Identify the components of the fraud triangle, explain how they would be assessed, and give a practical example of each.
1.) Management or other employees have an incentive or are under pressure that provides a reason to commit fraud. Example: you have a personal financial situation threatened, or immense pressure from management
2.) Circumstances exist that provide an opportunity for a fraud to be carried out. Example: Ineffective monitoring by management allows opportunity for fraud,or deficient internal controls in accounting system
3.) Those involved are able to rationalize committing a fraudulent act. some individuals possess an attitude, character, or set of ethical values that allow them to knowingly and intentionally commit a dishonest act. Example: committing to aggressive or unrealistic earnings forecasts could cause upper management to rationalize committing fraud to meet these expectations.
**Just because you meet all 3 of these points does NOT NECESSARILY MEAN you are committing fraud.
Describe the concept of "filling the assurance bucket". Identify how the various components are determined based on the desired level of assurance. Give an example of each of the various components of the assurance bucket.
Filling the assurance bucket is a way for auditors to view how much evidence they need until they are comfortable enough to be able to issue an opinion on the client's information and be able to support that opinion. It is a visual representation that requires satisfaction of risk assurance procedures first (ex: Existence or occurrence), then test of controls (ex: cutoff), then substantive analytical procedure (ex: accuracy or valuation), and finally test of details (ex: rights and obligations) for any remaining assurance needed. The bottom parts of the bucket must first be satisfied before the parts about it can be.
Lower-risk accounts can possibly have assurance bucket filled with test of controls and stubstantive analytical procedures. The size of the bucket can vary depending on the auditor's risk assessment and assertion being tested. It is a subjective matter that requires considerable professional judgement.
Identify and explain the functions of audit documentation.
Audit documentation is anything that is given to the auditor by the client. This is used for testwork and must be kept for 7 years following the audit as mandated by the PCAOB. The purpose of audit documentation is to tie information to the financial statements to understand where numbers came from and how they were generated.
Audit Documentation (working papers) has 3 functions:
1.)To provide support for the audit report: when the engagement is complete and the audit report is issued, the basis for the decision rests in all of the evidence gathered in the working papers and this documentation provides the support of the opinion that is issued.
2.)To aid in the planning, performance, and supervision of the audit: The documentation show the auditor's compliance with auditing standards (specifically, compliance with the standards of fieldwork). The planning of engagement and execution of that plan is included in these work papers.
3.)To provide the basis for the review of the quality of the work by providing a written documentation of the evidence supporting the auditor's significant conclusions: The working papers are the focal point for reviewing the work to subordinates and for quality control reviewers.
Assume that you are the new audit senior on the LV Drug Corporation (LVD) engagement. LVD is a pharmaceutical company that has three successful drugs and a number of drugs in progress in its research and development pipeline. You are considering your audit plan and it is important to identify the inherent risks that LVD has and how they relate to the planning process.
For each of the following factors, indicate whether it will tend to increase, decrease, or have no effect on inherent risk, and the reasoning for your answer.
a.) Dr. Jones is the major shareholder of LVD and its CEO.
b.) Your firm has audited LVD for the last four years.
c.) There has bee high turnover of key accounting personnel during the last two years.
d.) The internal audit function reports to the audit committee
e.) LVD has been the subject of lawsuits by users of Framadon who claim that the drugs affect their liver functions. LVD is confident that there are no such side effects from the use of Framadon.
No idea...Check with Wilson.
a.) Dr. Jones is the major shareholder of LVD and its CEO:
Increase. He has a lot of control over the company and has an incentive to make a gain on his investment being a major shareholder.
b.) Your firm has audited LVD for the last four years: Decrease. It would decrease if the past four audits have been positive and no fraud or material misstatements existed.
c.) There has been high turnover of key accounting personnel during the last two years:
Increase. It would cause higher risk because of high turnover. What is the reasoning for the turnover. If it was because the personnel felt immense pressure, fraud could exist and higher inherent risk.
d.) The internal audit function reports to the audit committee:
Decrease. This is a good thing to have in place because audit committee is an independent function of the board of directors.
e.) LVD has been the subject of lawsuits by users of Framadon who claim that the drug affects their liver functions. LVD is confident that there are no such side effects from the use of Framadon:
Increase. Inherent control cannot be managed, so any lawsuit effects that would cause LVD to pay fines, etc. would increase the risk inherently present in the company.