accounting auditing Flashcards
What should be included for the Auditor’s address?
The City and State where located
What is Management Responsible for in regards to the Financial Statements?
Preparation and Fair Presentation of Financial Statements in accordance with the Applicable Financial Reporting Framework
What is Management Responsible for in regards to Internal Control?
Internal Control Design, Implementation, Maintenance
What are the headings in the Audit Report for an Unmodified Opinion?
(TIM-AA) Title; Introduction; Management Responsibility; Auditor Responsibility; Audit Opinion
What are the headings in the Audit Report for an Modified Opinion?
(TIMA-BA) Title; Introduction; Management Responsibility; Auditor Responsibility; Basis for (Modified) Opinion; Audit Opinion
In an Unmodified Opinion with Emphasis-of-Matter / Other-Matter sections, what is the order of the headings?
(TIM-AA EMO) Title; Introduction; Management Responsibility; Auditor Responsibility; Audit Opinion; Emphasis-of-Matter; Other-Matter
What are the requirements for referencing a Component Auditor in the Audit Report?
Component Financial Statements must be prepared using same Financial Reporting Framework as the Group Financial Statements; Component Auditor must have performed audit in accordance with GAAS or PCAOB Standards.
What must the Group Engagement Partner do if they assume responsibility for the Component Auditor’s work?
Perform additional audit procedures; Be involved in Component Auditors work; Perform Risk Assessment procedures; Assess Risk of Material Misstatement
What standards govern SSARS engagements?
Compilations are governed by SSARS (Statements on Standards for Accounting and Review Services)
Which clients can have compilation engagements?
Non-SEC (non-public) registrants only.
What is a Compilation?
Accountant puts together financial statements with information PROVIDED BY MANAGEMENT. No opinion is expressed and no assurances are given. Independence is not required.
What disclosures are required for Compilation engagements?
Disclosures not necessary must state that they are not included
What standards govern Review engagements?
SSARS (Statements on Standards for Accounting and Review Services)
What type of assurance is given in a Review engagement?
Reviews give limited assurance.
What procedures are required for Review engagements?
Analytical procedures are required for reviews. Compare results to documented predictions.
What is a Review engagement?
Financial statements are presented with no opinion expressed- and limited assurances are given. Independence is required for a review engagement.
What is a Forecast?
A prospective financial statement that uses normal circumstances. General and limited use allowed.
What is a Projection?
A prospective financial statement using hypothetical situations. Only limited use by the client is allowed.
What are the requirements for Agreed Upon Procedures?
Independence is required; Only limited use by the client is allowed.
What disclosures are required for remote likelihood of losses?
No disclosure required.
What disclosure is required for a probable loss contingency?
Accrue if estimable. Emphasis-of-Matter paragraph if not estimable.
What disclosure is made if a loss contingency is reasonably possible?
Auditor assesses need for Emphasis-of-Matter paragraph based on loss likelihood.
How is a gain contingency reported?
Gain contingencies are not reported.
How does an immaterial GAAP issue affect the audit opinion?
It doesn’t. Opinion is Unmodified.
How does a very material GAAP issue affect the Audit Report?
Modified-Adverse Opinion is issued. Emphasis-of-Matter paragraph is added after Opinion paragraph.
How do GAS standards compare to GAAS?
GAS is more strict than GAAS.
What is required under the Single Audit Act?
An audit performed under governmental auditing standards (GAS). A report on internal control is required. GAAS and GAS don’t require the I/C report.
What is Audit Sampling?
Taking part of a population- subjecting it to audit procedures- projecting results to a population
What are the characteristics of Statistical Sampling?
Based on formulas
Helps find an appropriate audit sample
Helps evaluate evidence obtained
Helps evaluate results and quantify Sampling Risk
What are the characteristics of Non-Statistical Sampling?
Based on human decision
Equally acceptable as Statistical Sampling
What are the characteristics of Substantive Tests?
Variables sampling
Probability proportionate to size sampling
What type of sampling are Control Tests?
Attribute Sampling
What is Sampling Risk?
Risk that your sample isn’t representative of population
Can happen even if audit is done properly
What is the risk of assessing Control Risk too high?
A risk of Control Testing - Auditor works to make Control Risk lower
More substantive tests - Sample overstates Control Risk- Leads to an under-reliance on internal control- over-testing- and overall audit inefficiency
Audit ends up being effective (correct result)- but you do more work
What is the risk of assessing Control Risk too low?
A risk of Control Testing - Complement to Confidence Level
Inverse relationship to Sample Size
Higher accepted risk of assessing Control Risk too low = Smaller Sample
Lower accepted risk of assessing Control Risk too low = Larger Sample
What are the risks if the auditor concludes controls are operating effectively based on the sample and Control Risk is set too low?
Leads to higher Detection Risk - Fewer substantive tests
Sample understates Control Risk
This error leads to over-reliance on internal control- under-testing- and overall audit ineffectiveness.
Does NOT necessarily mean that the Financial Statements are materially misstated - it does mean that if there is one- you are less likely to find it
What is the risk of Incorrect Acceptance?
A risk of Substantive Testing - Auditor accepts a balance as fairly stated- when in fact it is not fairly stated
Hurts audit effectiveness
Wrong conclusion reached
Efficient- but not effective
What is the risk of Incorrect Rejection?
A risk of Substantive Testing - Auditor rejects balance as fairly stated when in fact it is fairly stated
Hurts audit efficiency
Wrong recommendations given
Effective- but not efficient
What is Non-Sampling Risk?
Risk of human (auditor) missing an error
Also called exception- error or deviation.
How does Sampling Risk compare to Non-Sampling Risk?
Sampling Risk deals with the chance that your audit sample is flawed
Non-Sampling risk deals with the chance that your human decisions/conclusions are flawed
What is Attribute Sampling?
Looking at Control Procedures - Were invoices approved when paid?
Errors are stated in terms of %- not dollar amounts
For example- 5 invoices out of 100 were not properly paid. Error rate is 5%
Hint: If you see Error Rate on the Exam- they are referring to Attribute Sampling.
How do you determine if Control Procedures are operating properly or not operating properly?
Control Procedures are either operating properly or they are not operating properly - based on Error Rate and the tolerance you have for errors
What is the Tolerable Rate?
Error rate in population that you are willing to accept/tolerate
Inverse relationship to Sample Size
Higher Tolerable Rate = Smaller Sample
Lower Tolerable Rate = Larger Sample
If you’re willing to accept a higher probability that errors exist- there is less pressure on the sample
What is the Expected Population Error Rate?
What Error Rate are you expecting? - Judgment call- based on experience
Direct relationship to Sample Size
More errors = Larger Sample
Less errors = Smaller Sample
What is the basic premise of Attribute Sampling?
Attribute in the sample gives information about the entire audit population
Used to estimate Internal Control error rate
For what is the Expected Population Deviation (error) Rate used?
Used to determine initial level of Control Risk
What is the Allowable Risk of Over-reliance?
Risk of Assessing Control Risk too low
Gives you the Sampling Risk
When is Attribute sampling used?
Attribute sampling is only useful when there is documented evidence (an audit trail) to test
Use when the existence of an error needs to be verified or debunked
What is Classic Variable Sampling?
Testing for a dollar amount
Value in sample gives information about value in entire population.
What functions are used in conjunction with Classic Variable Sampling?
Mean Per Unit = Sample Average x Number in Population
Stratification - Decreases effect of variance in population and reduces sample size
What are the characteristics of Probability Proportionate to Size (PPS) sampling?
A form of Variable Sampling
Does NOT use Standard Deviation
Auditor focuses on a dollar amount
Larger or more valuable items get picked more often as part of the sample
What is Projected Misstatement?
Misstatement found in sample - have to project it to remainder of population
How does Probability Proportionate to Size (PPS) sampling compare to Classic Variables sampling?
PPS:
Easier to use- Results in a stratified (homogenous) sample- Results in a smaller sample size to audit- Easy to design
Classic Variables Sampling:
Easy to expand sample size- Selecting zero and negative balances easy
What factors affect sample size?
Tolerable rate for error - Inverse relationship with sample size
Risk of assessing Control Risk too low - Inverse relationship with sample size
Expected population error rate - Direct relationship with sample size
Population size does NOT affect the sample size - as population is larger- sample size doesn’t grow.
What is the formula for Audit Sampling?
SER + ASR < TER
SER = Sample Error Rate
ASR = Allowance for Sampling Risk
TER = Tolerable Error Rate
What is Allowance for Sampling Risk?
The amount that you add to the Sampling Error Rate to get some cushion for your sample.
As high as you think the population error rate could go based on experience.
What is the Tolerable Error Rate?
The amount of error rate that you can accept - If population error rate is less than TER- then accept the Control as effective
If population error rate is more than TER- do more testing to get SER lower or conclude control isn’t effective. Do more substantive testing
What are the steps to develop a sampling plan?
Determine Test Objective - for example- have sales shipments been billed?
Define Population and Deviation - take a sample of shipping document- trace forward to see if billed
Determine Sample Size based on tolerable rate for error- risk of assessing Control Risk too low- and expected population error rate.
Select Sampling Technique
After a Sampling Plan is developed- what are the steps in sampling?
Perform the Sampling Plan
Evaluate Results
Document Results
What is Systematic Sampling?
Every certain # of a population is selected
Population needs to be randomly ordered
Primary advantage is that population doesn’t require pre-numbering
What is Sequential Sampling?
Also called Stop or Go sampling
Each audit step determines the next step
What is Discovery Sampling?
Audit is testing an area that is so crucial that zero population errors can be tolerated
Any phony employees on payroll?
How does Block Sampling compare to other sampling methods?
Easy to implement- but is the worst method of sampling.
What is the primary duty of an auditor?
To provide users of financial information with REASONABLE ASSURANCE that the financial statements are not materially misstated.
What is the auditor’s responsibility for detecting theft or fraud?
Auditors are not responsible for detecting theft or fraud.
Instead- they are responsible for providing REASONABLE ASSURANCE that the financial statements are not materially misstated.
When should an auditor be hired in relation to the balance sheet date for optimum audit planning and efficiency?
The earlier the auditor is hired- the better for audit planning and efficiency.
When can audit procedures be performed at interim dates?
If Control Risk for the accounts and/or transactions is low- audit procedures can be performed at interim dates.
The auditor then reviews changes in the balances at year-end.
When can an auditor accept an engagement offered after the year is already closed?
The auditor can take the engagement if they are able to overcome the limitations of the engagement.
For what does an auditor use professional skepticism?
To plan the scope of the audit
To plan the objectives of the audit
How can analytical procedures be performed in audit planning?
The auditor can compare actual versus forecasted numbers.
What must an auditor have in order to discuss issues relating to a predecessor auditor’s work?
If issues relating to predecessor auditor’s work on previous Financial Statements come up during the current audit- Auditor must have client’s permission to discuss the issue.
What questions must an auditor ask with respect to procedures carried out by assistants?
Were they adequately performed? (Review the working papers)
Are the results consistent with the audit report?
How is audit strategy mapped out?
Auditor determines what the reporting objectives are.
Auditor determines the scope of the audit.
Describe the key components of maintaining auditor independence.
Auditor must be independent in fact and appearance
Honesty
No direct financial interest
No indirect material financial interest
Describe Due Professional Care
Technical abilities mirror those held by peers in the profession
Follow GAAS Standards
Obtain a Reasonable Level of Assurance
Maintain Reasonable Level of Skepticism
Supervise Audit Staff
Review judgment at every level
What should an auditor do prior to accepting an audit engagement?
Review the previous financial statements
Speak to third parties
Contact predecessor auditor to evaluate whether engagement should be accepted (must have client permission)
What questions should be asked by an auditor prior to taking an engagement?
Note: must have permission of client to contact predecessor auditor (no permission = no engagement)
Why the Auditor Change?
Any Serious Discussions with Audit Committee?
How is Management Integrity? Disagreements?
How was Internal Control?
Understand Industry or Be Willing to Learn
Consider Scope Limitation - Limited evidence available = no engagement
What should be included in an audit engagement agreement?
Note: must be written
Objectives of Engagement
Limitations of Engagement
Responsibilities of Management - Provide written assertions
Responsibilities of Auditor - Limited error/fraud responsibility
Expectations of Access to Records
Financial Statements (and Disclosures) are Management’s Responsibility
Compliance with Laws
Internal Control
What is management’s responsibility with respect to the financial statements?
Management is responsible for financial statements and adequacy of disclosures.
Presentation & Disclosure
Existence (Tests Overstatements)
Rights & Obligations
Completeness (Tests Understatements)
Valuation & Allocation
What is the purpose of the Audit Committee?
Responsible for Hiring Auditor
Oversees Internal Control
Must Agree with Auditor on: Responsibility of the Parties- Audit Fee- Timing of the Audit- Audit Plan
Acts as Liaison Between Auditor and the Board
Auditor Communicates Concerns about: Internal Control Deficiencies- Errors- Fraud- Illegal Activities
How is Audit Risk calculated?
Inherent Risk x Control Risk x Detection Risk
Risk that material mistakes- errors- omissions- or fraud will result in an inaccurate audit report
Based on Auditor Judgment
Measured in both Qualitative and Quantitative
Describe Control Risk
Risk that internal control will not detect error or fraud
Auditor cannot control this.
Describe Inherent Risk.
Which transactions have a higher level of risk?
Auditor cannot control
Describe Detection Risk.
Will the auditor fail to detect a material misstatement?
Auditor CAN control
Do testing at year-end
Increase substantive testing
Run more effective tests
What responses should an auditor take based on different levels of acceptable detection risk (DR)? What type of tests should be performed?
Less Acceptable DR = Run More Substantive Tests
More Acceptable DR = Run Less Substantive Tests
More Substantive Tests (DR down) = Less Audit Risk; (AR = IR x CR x DR)
Less Substantive Tests (DR up) = More Audit Risk; (AR = IR x CR x DR)
What are quantitative measurements versus non-quantitative measurements with respect to risk?
Quantitative Measurements - Inherent- Control- and Detection Risk can all be measured in terms of percentages
Non-Quantitative Measurements - Inherent- Control- and Detection Risk can all be measured in terms of acceptable ranges
Whose responsibility is it to FIND and PREVENT fraud?
It is Management’s responsibility.
What is the auditor’s responsibility with respect to fraud and illegal acts?
Assess the RISK that such things will lead to material misstatements
Design the audit to provide reasonable assurance against fraud- illegal acts that directly and materially affect the financial statements
Report ALL management fraud to the audit committee (minor fraud by low-level employees not reported to committee)
Perform required inquiries and procedures (management inquiries- analytical procedures- discussions with audit personnel about fraud)
What are the three factors that affect/influence fraud?
Fraud is born out of:
Rationalization
Incentive
Opportunity
(RIO)
What is the difference between fraud and errors?
Errors are unintentional- fraud is intentional.
What red flags may indicate higher risk in an audit?
Management compensation tied to stock
Aggressive financial forecasting
Former auditor disagreed with Management
Records not available for audit
Current audit procedures may need to be reconsidered if red flags exist.
Describe the characteristics of a Fraud Risk Factor.
Has been observed in similar situations
Does NOT necessarily mean that there is a material weakness in internal control
Leads to an auditor taking action
What does an examination of internal control accomplish with respect to illegal acts?
Internal control analysis can result in the conclusion that IC is weak- but probably won’t identify illegal acts
What is the purpose of adjusting audit procedures in light of fraud risk factors identified during an audit?
Strives to make audit engagement procedures less patterned and predictable
Re-evaluates management’s application of accounting procedures
Finds and assigns audit personnel with relevant skills in this area
What should be documented with respect to fraud risk factors in an audit?
Any fraud risks identified that could lead to material misstatement
Audit procedures performed to assess risks
Nature of communication made to audit committee and company management
Disclosure to third parties regarding fraud not normally the auditor’s responsibility
Fraud by management should normally be reported to the audit committee- NOT the SEC.
What was the effect of the SOX Act of 2002?
Created PCAOB
Designates Officer responsibility for internal control
Must disclose significant internal control weaknesses to auditor and audit committee
Must disclose any level of fraud discovered by employees with internal control responsibilities
What is the Hierarchy of Authoritative Literature?
- Statements on Auditing Standards (SAS)
- Auditing Interpretations- AICPA Guides & SOPs
- Industry Articles (no authority)
What quality control activities are undertaken by CPA firms with audit practices?
Firm Leadership exhibits quality and leads by example and sets the tone for the organization
Firm should Monitor and document that its policies and procedures are being followed
Firm should have Relevant Ethical Requirements
Acceptance and continuance of client engagements should continue to be evaluated for client integrity- auditor competency- and legality
Firm should have competent and ethical personnel
Firm engagements are performed- supervised- and reviewed in accordance with professional standards and regulations.
Which literature governs Compilation services?
SSARS - Statements on Standards for Accounting and Review Services
These govern reporting for non-public entities only
What is the independence requirement for Compilations?
Independence NOT required for Compilations
No Internal Control work allowed
No assurance given
What type of assurance is provided by a Compilation?
Compilations are not an assurance service. No assurance is provided.
What type of assurance is provided by Review services?
Reviews provide NEGATIVE assurance.
What is the independence requirement for a Review?
Reviews require independence.
No Internal Control work allowed
Performs analytical procedures
No material indirect financial interest allowed
No immaterial direct financial interest allowed
For compilations and reviews- what knowledge must a service provider have?
Must have an understanding of the client industry.
What are attestation services?
CPA expresses a conclusion about an assertion - Compliance with laws
NOT considered a Consulting engagement
Independence Required
What is the independence requirement for consulting services?
Independence is not required for consulting services.
Describe the limitations on Prospective Financial Statements?
Report is restricted to specified users.
Agreed-upon procedures are implemented.
What is the role of the Group Engagement Team?
Develop Audit Strategy; Communicate with Component Auditors; Perform work on the Consolidation Process; Evaluate Audit Conclusions; Understand work of Component Auditors;
Who is on the Group Engagement Team?
Firm Partners; Group Engagement Partner; Audit Staff
Who establishes the Materiality threshold for the Component Auditor?
The Group Engagement Team; The Materiality threshold must be lower than the Group Materiality threshold
What is the Group Engagement Partner responsible for?
Group Audit Engagement Direction - Supervision - Performance and the Audit Report
What is the role of a Component Auditor
Audit a component of the entity
What should the Group Engagement Team do if a Component Auditor audits a Significant Component due to Financial Materiality?
Audit the Financial Information
What should the Group Engagement Team do if a Component Auditor audits a Significant Component due to Risk of Material Misstatement?
Perform Audit Procedures
What should the Group Engagement Team do if a Component Auditor audits a Non-Significant Component?
Analytical Procedures performed at Group Level
Why does an Auditor do if they suspect legal proceedings could contribute to a Material Misstagement?
Contact Client external counsel through a Letter of Inquiry
What is the majority of an auditor’s work in determining an audit opinion?
Collection of evidence to support the opinion.
Of what does audit Evidence consist?
Evidence consists of client accounting data and supporting documentation from client or from third parties.
What is the relationship between Evidence and Detection Risk?
Evidence has an inverse relationship with Detection Risk
The one aspect of Audit Risk an auditor can control through (N)ature (T)iming (E)xtent of audit procedures.
Inherent Risk and Control risk are outside of auditor’s control.
Which aspects of Audit Risk can an auditor control?
Detection Risk which is decreased by gathering evidence.
Which aspects of Audit Risk can an auditor NOT control?
Inherent Risk and Control Risk are outside of an auditor’s control.
How does a high level of acceptable Detection Risk affect an audit?
Less Evidence collected. Opens door for incremental audit risk - Internal Control should be strong.
Business and transactions should be relatively stable and predictable.
(N) Less-competent Evidence collected
(T) Interim testing acceptable
(E) Fewer transactions are verified.
What should occur when a low level of Detection Risk is acceptable?
More Evidence collected
(N) More-competent Evidence collected
(T) End of year balance testing
(E) More transactions are verified
What are the primary risks in an audit for a typical for-profit company?
Auditors are there to verify that
Assets & Revenues are not overstated
Expenses & Liabilities are not understated
Exception - if the CPA Exam states that it is a tax-driven company flip them around
What is the primary constraint on audit evidence?
Cost vs. Benefit is a primary constraint.
What characteristics should audit evidence have?
Sufficient (quantity)
Appropriate: Relevant & Reliable (Quality)
How does the quality of audit evidence vary depending on who has provided it?
Best evidence: Observation of activity by auditor.
2nd Best: Originates from External Parties and is sent directly to auditor (or failing that items are generated by third party and provided to auditor by the client such as a bank statement)
Weakest: Oral evidence from management.
Which documents are the most persuasive and credible?
Third party documents are more persuasive and credible than internally-prepared docs
Auditor Knowledge = Most Persuasive
3rd Party info given to auditor
3rd Party info given to client
Internally-prepared doc
What are Substantive Procedures?
Test substance/amounts/values. They help to reduce the risk of material misstatements. They only test accuracy of financial statements and dollar amounts - they don’t test internal controls.
What are the substantive tests that are most often performed?
Trace (or Vouch) Reconcile Analytical Procedures Confirmations Examine evidence that supports management assertions.
(T.R.A.C.E.)
When performing audit procedures what should auditors focus on?
Auditors focus first on Balance Sheet Accounts then associated Income Statement items
How is Cash audited?
Assurance Level is High.
Acceptable Detection Risk is Low.
How is Accounts Receivable audited?
If Acceptable DR is High - Negative Confirmation is used - Customer only responds if balance is materially wrong.
If Acceptable DR is Low - Positive Confirmation is used - Customer asked to confirm by telling auditor the balance.
Corresponding Income Statement Account - Revenue
How is Accounts Payable audited?
Review purchase orders/invoices
Confirm with Vendors
Corresponding Income Statement Account - Various Expenses
How is Inventory audited?
Examine purchase agreements
Look at Board Minutes
Is Inventory held as collateral?
Corresponding Income Statement Account - COGS
How are beginning balances audited?
Should match last year’s ending balance.
What is the general presumption for auditing Ending Balances?
If Beginning Balance Additions Subtractions are OK then Ending Balances should also be OK.
How is a Statement of Cash Flows audited?
Foot all balances - Check the Math
Trace Cash Flow items to other Financial Statements
Check classifications - Operating Activities Investing Activities Financing Activities
Under the Indirect Method what must be disclosed on a Statement of Cash Flows?
Interest Paid
Income Taxes Paid
Non-cash Transactions
Cash and Cash Equivalents Definitions
Under the Direct Method what must be disclosed on a Statement of Cash Flows?
Results as if you had used Indirect Method
Non-cash Transactions
Cash and Cash Equivalents Definition
What are Subsequent Events and what do they require?
Subsequent events occur after the Balance Sheet Date but before the audit report is issued.
Auditor needs to make inquiries and assess if they affect the audit report.
What should occur if the audit report has already been issued and the auditor becomes aware of a situation that was present as of the Balance Sheet date (a subsequent event)?
If audit report has already been issued and auditor becomes aware of a situation that was present as of the BS date client should issue a disclosure to financial statement users and/or revise the financial statement.
Regulatory agencies might need to get involved under some circumstances.
What should an auditor do if they discover they have forgotten to perform a substantive procedure?
If auditor discovers that they forgot to perform a substantive procedure auditor should determine if other substantive procedures performed served as a substitute.
Otherwise support for their audit opinion could be jeopardized.
When are Analytical Procedures required?
REQUIRED When planning the audit (preliminary)
REQUIRED When reviewing the audit (final)
Analytical procedures may be also performed optionally along with the substantive testing.
Use of Analytical Procedures in the audit must be documented.
How do Analytical Procedures assist the auditor?
Helps the Auditor:
Determine if Management Assertions are reasonable
Develop audit plan
Develop some expectations about the financial statement and hopefully bring to light any glaring errors on financial statement
What is the focus of Analytical Procedures?
Analytical Procedure focus is on dollar amounts (not internal controls)
Analyzes Financial Data: Do Financial Statements Make Sense?
Comparison of data between years
How is the Current Ratio calculated?
Current Ratio = Current Assets / Current Liabilities
How is the Quick Ratio calculated?
Quick Ratio = Liquid Assets / Current Liabilities
How is the Asset Turnover calculated?
Asset Turnover = Net Sales / Average Assets
How is the Inventory Turnover calculated?
Inventory Turnover = COGS / Average Inventory
How is Gross Margin % calculated?
Gross Margin % = Gross Margin / Sales
What type of testing are ratios?
Ratios are Analytical Procedures
What type of procedure is a Budget vs. Actual comparison?
Budget vs. Actual comparisons are Analytical Procedures.
List Common Types of Analytical Procedures
Ratio analysis
Budget vs. Actual comparison
Comparison of data between years
Use of non-financial data to predict expected values for financial data
How do management assertions affect the audit?
Management assertions help the auditor to plan the audit and select substantive tests.
What assertions do auditors test?
Presentation - Cutoff Classification - Is it in the right period and category?
Existence/ Occurrence - Did it happen? Does it exist?
Rights & Obligations - Does the company own them?
Completeness - Was everything recorded?
Valuation - Are they worth the amount at which they are recorded?
(PERCV)
What assertions are tests for transaction classes?
Occurrence
Cutoff
Classification
Completeness
Accuracy
For which assertions are disclosures tested?
Occurrence
Completeness
Classification
Accuracy
Is testing the validity of direct evidence a basic audit procedure?
No it is an extended procedure.
For example you don’t have to take a loan covenant document and go search out that it’s a valid loan covenant. Instead you consider the source - if it’s externally prepared it’s more persuasive.
How are Management Estimates audited?
First and foremost you need to understand management’s rationale and methods for developing estimates before you can judge reasonableness.
Next Auditor should formulate their own opinion on what a good estimate should be and compare it.
Finally determine if subsequent events affect the estimate.
Whose property are audit documentation (audit workpapers)? In what form must they be?
Audit workpapers are the property of the auditor.
They can be paper or electronic.
They must include a WRITTEN audit program (either paper or electronic).
What is the Current File?
Information pertaining to the current year’s audit.
What is the Permanent File?
Information used for this audit and future audits which is updated as needed.
How long must audit workpapers be maintained?
Must be kept for 5 years after the audit release date or according to regulations whichever is longer.
Must be kept for 7 years under PCAOB Audit
PCAOB audits also require an Engagement Completion Document
What is the primary requirement for audit workpapers besides being written?
Any experienced auditor should be able to look at your work and understand what you did.
How should documents added to work papers be treated?
If further documents are added to the work papers after the audit report is issued it must be documented as to who added them why they were added and any effects on the audit report.
How should documents removed from workpapers be treated?
After the audit report is released the firm has 60 days to subtract from the file.
You can still add to the file if you document it but you cannot delete any information after 60 days.
Note - for SEC auditors the PCAOB only allows deletions up to 45 days after issuance of the audit report.
Which IT personnel roles should always be segregated?
Operators
Programmers
Librarians
What are the duties of a systems analyst?
Designs or purchases IT system
Responsible for flowcharts
Liaison between Users and Programmers
Note: Think IT Manager
What is the primary duty of a Systems Administrator?
A Systems Administrator controls database access.
What are the duties of a Systems Programmer?
Writes- Updates- Maintains- & Tests software- systems- and compilers
Which duties should a Systems Programmer NOT have?
In order to maximize internal control- a Systems Programmer should NOT have application programming duties/abilities or be an Operator on the system.
What are the duties of a Systems Operator?
Schedules and Monitors Jobs
Runs IT Help Desk
What duties should a System Operator NOT have?
For internal control purposes- they should not be a Programmer on the system.
If it is not possible to segregate duties in an IT System- what actions should be taken to compensate for internal control purposes?
Include Computer Logs.
Control Group should review the logs.
What is the purpose of a Management Information System (MIS)?
To assist with decision making.
What is an Accounting Information System (AIS)?
A type of Management Information System (MIS) that processes accounting transactions.
What are the characteristics of an Executive Information System (EIS)?
Specialized for Company Executive needs
Assists with Strategy Only
No Decision-Making Capabilities
What are the characteristics of an Expert System (ES)?
Computer uses reasoning
Structured
No human interpretation needed
What are the characteristics of a Decision Support System (DSS)?
Computer provides data
Gives Interactive Support
Human interpretation needed
What are the characteristics of an Ad Hoc computer report?
User initiates the report.
The report is created upon demand.
When are Exception reports generated?
Exception reports are produced when Edit Tests- Check Digits- or Self-Checking Digits identify a problem
What is a query?
A type of Ad Hoc report- initiated by a user.
What is End-User Computing?
The User develops and executes their own application.
What is the primary benefit of E-commerce?
E-commerce makes business transactions easier.
What are the risks of E-commerce?
Compromised data or theft.
Less paper trail for auditors.
What are the benefits of Electronic Data Interchange?
Uses globally-accepted standards
Efficient
What is a File Server?
A file server stores shared programs and documents.
What is the purpose of a Database?
Located on a File Server- a Database allows users to share documents.
What is the purpose of a LAN (Local Area Network)?
It connects computers in close proximity.
What is the purpose of a WAN (Wide Area Network)?
It connects computers that are far apart.
What are the characteristics of a VAN (Value-Added Network)?
Privately-owned Network
Serves as 3rd Party Between 2 Companies
Routes EDI Transactions
Accepts wide range of Protocols
Very Costly
What is the purpose of a Firewall?
Prevents unauthorized access to a network.
What are the characteristics of a virus?
Takes over a computer
Needs a host program to run
What are the characteristics of a computer worm?
Takes over multiple computers
Doesn’t need a host program to run
What is the purpose of Automated Equipment Controls?
They prevent and detect hardware errors.
What is RAM?
Random Access Memory.
Internal memory in the computer used during immediate processing.
What is a CPU?
Computer Processing Unit
It processes commands within a computer.
What is Job Control Language?
It schedules and allocates system resources.
What are examples of input devices?
Keyboard
Mouse
Scanner
Magnetic Ink Reader
Magnetic Tape Reader
EDI
Point of Sale Scanner
What are examples of Output Devices?
Speakers
Monitors
Printers
What are the characteristics of Magnetic Tape storage?
Sequential Access - Sorts data in order
Slower data retrieval
Header Label prevents Operator error by loading wrong tape
External Labels prevent accidental destruction by operator
What are the characteristics of Magnetic Disks?
Random Access - Finds data in random spots
Faster data retrieval
Uses Boundary Protection for data
What is a Gateway?
Connects one network to another
Note: the Internet is connected by Gateways
What are Parity Checks?
A control that detects internal data errors.
A bit is added to each character- it checks to see if a bit was lost.
What is an Echo Check?
Transmitted data is returned to the sender for verification (it echoes back to the sender)
What is a Change Control?
It authorizes program changes and approves program test results.
What is security software?
Software that controls access to IT systems.
Note: Don’t confuse this with anti-virus software
What is the purpose of a Digital Signature?
It confirms a message has not been altered.
List the types of computers from smallest to largest
PDA/Smartphone/Tablet
Microcomputer - PC- Laptop (cost-effective)
Minicomputer - Like a Mainframe- but smaller
Mainframe - Large computer with terminals attached
Supercomputer - Very powerful and very big
What are the units of computer data from smallest to largest?
Bit - 1 (on) and 0 (off)
Byte - 8 bits to a byte/character
Field - group of related characters/bytes (i.e. Name- Zip Code- Serial #)
Record - Group of related fields (i.e. Member name- address- phone number)
File - Group of related records (i.e. Membership directory)
What is the duty of a design engineer?
Determine language used for a specific computer- on a computer-to-computer basis
What are object programs?
Programs written in base computer language- not similar to English.
How can source programs be recognized?
They are written in a language close to English.
What is the purpose of a Compiler?
Takes Source language (English) and converts to Object (Computer) Language
How does Online Analytical Processing work?
It uses a Data Warehouse to support management decision making.
What is Data Mining?
Using artificial intelligence and pattern recognition to analyze data stores within a Data Warehouse.
What is the purpose of online transaction processing?
To process a company’s routine transactions.
What are the characteristics of batch processing?
Data held- updates multiple files all at once
Leaves a better audit trail
Uses Grandfather-Father-Son backup (3 levels of backup kept in 3 locations)
What does an output control check for?
Checks to see if output data is valid- distributed and used in an authorized manner.
What does a processing control check?
Checks if data processing produced proper output
What is a hash total?
An input control number- a meaningless sum of values included in the input.
Example would be summing a list of SSNs to make sure the data is the same once entered as it was prior to input into the system.
What is a validity check?
Checks to see if data in existing tables or files belongs in the set
For example- is there a # in an alpha-only field or a letter in a numeric-only field
What is a limit check?
Checks to see if numbers surpass a certain limit- i.e. in an age field is the number greater than 110.
What is a check digit?
An input control that adds an identification number to a set of
digits - usually at the end
What is a field check?
An input check that prevents invalid characters- i.e. checks for alphabetic letters in a SSN field
What is a Hot Site?
A disaster recovery system where if the main system goes down- a Hot Site is ready to take over immediately.
What is a Cold Site?
If a main system goes down- a Cold Site will take time to get set up and running.
What is the most common database language?
SQL - Structured Query Language
What is a Data Definition Language?
Defines SQL Database
Controls SQL Tables
What is a Data Manipulation Language?
Queries SQL Database tables
What is a Data Control Language?
Controls Access to SQL Database
What are the characteristics of a Relational Database?
Logical structure
Uses rows and columns similar to spreadsheet
What are the characteristics of a Hierarchical Database?
Has various levels
Uses trees to store data
What are the advantages of a database?
Data is more accessible
Reduced redundancy
What are the disadvantages of a database?
Cost of installation
Skilled personnel required to maintain
What are the components of a database?
Desktop client
Application Server
Database Server
Think: Your desktop computer runs applications and saves to a database
If Internal Control is poor and a company’s accounting practices are sloppy - which risk is higher?
Control risk increases with poor Internal Controls and sloppy accounting practices.
If Internal Control is poor - what is the effect on the audit?
Auditor will need to perform more testing and dig deeper into accounts in order to arrive at an opinion regarding the financial statements.
What does Internal Control provide reasonable assurance for?
Internal control provides reasonable assurance that
Material misstatements will be prevented
Reliability/integrity of financial statements will be preserved
Assets are protected against misuse
What is required in an examination of Internal Control under Sarbanes-Oxley?
CEO/CFO must disclose Internal Control deficiencies
Management must provide assessment of Internal Control
Management must certify Financial Statements
What is the relationship between Internal Control and Substantive Testing?
Inverse Relationship
Stronger Internal Controls - Less Testing Needed
Weaker Internal Controls - More Testing Needed
What are the 3 objectives of Internal Control?
Reliability of Financial Reporting
Operational Efficiency/Effectiveness
Compliance with Law and Regulations
What are the 5 components of Internal Control?
Control Environment
Risk Assessment
Information and Communication
Monitoring
Control Activities
What is the purpose for a Control Environment assessment?
Sets tone for the entire company
What are the components of the Control Environment?
Integrity/Ethics of Management
Competence of Management
Organizational Structure
Human Resource Policies
Assignment of Authority/Responsibility
Management’s Style (riskier with a dominant/aggressive individual)
Board/Audit Committee involvement
What does an auditor’s assessment of Detection Risk determine?
Detection Risk determines nature- timing- and extent of audit procedures.
What determines the acceptable level of Detection Risk?
Risk of material misstatement determines acceptable level of Detection Risk
What items could increase the risk of material misstatement?
Rapid growth in the company.
The methods management uses to identify risk- estimate its significance and assess the likelihood of occurrence
Major changes to operations- personnel- systems- IT- products- corporate organization- and foreign operations.
What happens when Control Risk is assessed to be at the maximum level?
No Internal Control testing is performed.
All audit procedures are increased in intensity to compensate for increased risk.
What happens when Control Risk is below the maximum level?
Auditor tests Internal Controls.
Auditor evaluates Control Risk based on tests
Auditor adjusts substantive tests accordingly
Weaker Internal Control - More substantive tests
Stronger Internal Control - Less substantive tests
Describe some common examples of Control Activities.
Performance Reviews
Information Processing
Physical Controls
Segregation of Duties
What should an auditor understand with respect to Information and Communication on an audit?
Understand Client’s
Major transaction classes
Transaction initiation
Support records/documents
Transaction processing
Financial Statement internal reporting process
Financial Statement external reporting process
How must an auditor document understanding of Internal Control?
Through written documentation such as Internal Control memos- flowcharts- and questionnaires
What questions should be asked to determine the risk of material misstatement?
Were all transactions recorded?
Were they timely?
Measured appropriately?
Recorded in correct period?
Presented and disclosed properly?
Did Management communicate their responsibilities?
What is the purpose of testing Internal Controls?
Auditor needs reasonable assurance that controls are functioning as designed and effective
Internal Control Testing should be strong as (IRON) so that nothing gets past them
Inquiry - Interview company personnel
Re-performance - Can it be replicated?
Observation - Watch the control be applied
INspection - Dig into the details/documents
If results are as expected- substantive procedures do not need to be adjusted
When can controls tested by an auditor in a prior year be used in the current year’s audit assessment?
Controls tested by auditor in a prior year can be used in the current year’s audit assuming they are re-tested every third year
Exception If the control has changed since the last audit
What happens if Internal Controls are deficient?
Control Risk increases
Scope of substantive procedures increases
Detection Risk decreases
Material Weakness - Reasonable possibility that a material misstatement in Financial Statements would not be found- more than a remote chance of occurrence
What is a Material Weakness?
Reasonable possibility exists that a material misstatement in Financial Statements would not be found- and has more than a remote chance of occurrence.
What does Tracing test?
Tests Completeness
Starts with source document and traces forward to the journal entry.
What does Vouching test?
Tests Existence.
Starts with a journal entry and searches for a voucher or source document to support the entry.
What activities represent Segregation of Duties?
Non-compatible duties performed by separate individuals- such as
Authorization of asset disbursement vs. Recording of Assets vs. Custody of assets
If supporting audit evidence doesn’t exit - use Observation and Inquiry
Accounting should be segregated from Production
With respect to signing checks - how are duties segregated?
Employees who prepare vouchers/invoices should not also have the authority to SIGN CHECKS
Tip - Remember this as an underlying theme with Segregation of Duties. The authority to make a payment should not also lie in the hands of those creating invoices/vouchers. Why? People commit fraud by setting up fake companies and basically paying themselves
With respect to custody of assets - how should duties be segregated?
Employees who have custody of assets should not also RECORD those assets
Someone in charge of petty cash should not also control the petty cash records
Treasury Department (custodians) should NOT have record keeping duties
They control assets and should not be able to adjust any recording of those assets
What are the limitations on Control Activities?
Controls can’t stop collusion or bad judgment
Management can override controls
Cost vs. Benefit relationship of Internal Control
What is required if a Material Weakness is identified?
A written report to management is required.
Report declaring that no material weaknesses were found is allowed
Previous weaknesses reported that still exist should be reported again
Should be reported no later than 60 days after audit report release date
If one or more material weaknesses is uncorrected at year-end- an Adverse Opinion on Internal Control must be given
What is the effect of a Significant Deficiency? What is it?
A significant deficiency adversely affects a company’s ability to report in the financial statements according to GAAP.
A significant deficiency is a more than a remote likelihood of material misstatement by more than an inconsequential amount
What must occur if a Significant Deficiency is identified?
If a Significant Deficiency is identified- a written report to management required
Report declaring that no significant deficiencies exist is not allowed
Previous deficiencies reported that still exist should be reported again
Should be reported no later than 60 days after the audit report release date
What is a Control Deficiency?
A control is not operating as intended.
What must an auditor ask if using the work of third parties?
Are they competent?
Are they objective?
What must an auditor understand with respect to internal auditors?
Auditor needs to understand the role of Internal Auditors within the organization because their work affects the audit plan
Responsibility for judgments about materiality or appropriateness of entries or estimates cannot be shared with third parties like Internal Auditors
Internal Auditors should be asked to do some of the legwork like preparing schedules or running reports
They should not be asked to make any decisions or judgments
What is required in an examination of Internal Control under Sarbanes-Oxley?
CEO/CFO must disclose deficiencies
Management must provide assessment of Internal Controls
Management must certify Financial Statements
What is the relationship between Internal Control and Substantive Testing?
Has inverse relationship
Stronger Internal Control results in LESS substantive testing
Weaker Internal Control leads to MORE substantive testing
What are the three objectives of Internal Control?
Reliability of Financial Reporting
Operational Efficiency/Effectiveness
Compliance with Law and Regulations
What are the five components of Internal Control?
Control Activities
Risk Assessment
Information and Communications
Monitoring
Control Environment
What are the components of the Control Environment?
Integrity/Ethics of Management
Competence of Management
Organizational Structure
Human Resources Policies
Assignment of Authority/Responsibility
Management’s Style (riskier with a dominant/aggressive individual)
Board/Audit Committee involvement
What happens when Control Risk is below the maximum level?
Auditor tests Internal Controls.
Auditor evaluates Control Risk based on tests
Auditor adjusts substantive tests accordingly
Weaker Internal Control - More substantive tests
Stronger Internal Control - Less substantive tests
What should an auditor understand with respect to Information and Communication on an audit?
Understand Client’s
Major transaction classes
Transaction initiation
Support records/documents
Transaction processing
Financial Statement internal reporting process
Financial Statement external communication process
How must an auditor document understanding of Internal Control?
Auditor must document understanding of Internal Control via Memos - Flowcharts - Questionnaires
What is the purpose of testing Internal Controls?
Auditor needs reasonable assurance that controls are functioning as designed and effective
Internal Control Testing should be strong as (IRON) so that nothing gets past them
Inquiry - Interview company personnel
Re-performance - Can it be replicated?
Observation - Watch the control be applied
INspection - Dig into the details/documents
If results are as expected - substantive procedures do not need to be adjusted
Who created the International Auditing Standards?
The International Auditing and Assurance Standards Board (IAASB)
Member of the International Federation of Accountants (IFAC)
For whom were IAASB International Auditing Standards created?
IAASB standards are for countries that don’t have their own standards and help set the tone for the rest of the members who do have their own standards (AICPA)
IAASB doesn’t override member standards
What financial approach is used under IAASB audit standards?
IAASB standards are based on a risk assessment approach
How do IAASB audit standards compare to US audit standards?
IAASB - No Internal Control audits
IAASB - No Referencing another Audit Firm
IAASB - Less detailed documentation
IAASB - Required: obtain written fraud assessment
IAASB - Required: location of auditor’s home office
What are International Ethical Standards?
Standards set by International Ethics Standards Board for Accountants (IESBA)
Code of Ethics for Professional Accountants - Similar to AICPA Code of Professional Conduct
Which groups are covered under the three sections of the International Ethical Standards?
A) Covers all accountants
B) Covers Public accountants
C) Covers accountants in a business environment
What are the requirements for all accountants under the International Ethical Standards?
Accountants should have Integrity
Accountants should be Objective
Accountants should have Competence
Accountants should exercise Due Care
Accountants should maintain Confidentiality
Accountants should act Professionally
What questions should public accountants pose to themselves under the International Ethical Standards?
What are the threats/safeguards?
Does this new client threaten our ethics?
What are the conflicts of interest?
What are the threats/safeguards for offering a second opinion?
What are the threats/safeguards for receiving commissions or contingent fees?
Is our marketing truthful?
What are the threats/safeguards for receiving client gifts?
What are the threats/safeguards to objectivity?
What is the purpose of a Consulting Engagement?
This engagement helps the client be more efficient with personnel and resources in order to accomplish their goals.
What is required by the Statements on Standards for Consulting Services (SSCS)?
Competence; Due Professional Care; Planning; Supervision; Obtain Sufficient Data; Serve Client Interest; Agreement: Written or Oral; Communicate w/ Client; Objectivity
NOT REQUIRED: Independence
What is the difference between Express versus Implied duties of an accountant under contract?
Express: Contract specifies what accountant will do
Implied: Accountant performs without negligence
Accountant’s liability for negligence - What are the requirements?
DUTY - DAMAGES - RESULT
Duty - Accountant must have had duty to perform with due care exercised by an average accountant.
Damages - The client experienced actual damages.
Result/Causation - The damages were as a result of the negligence.
What is an Accountant’s Liability for Detecting Fraud
(Under Normal Circumstances)?
It is not the accountant’s job to find fraud and they are not normally liable for not detecting it
When can a client be sued for failing to detect fraud?
When a normal audit following GAAS would have detected the fraud.
When an accountant agrees to take on more responsibility than what is required under a normal audit.
When accountant words the audit report to indicate this greater responsibility.
When has an accountant committed fraud?
Misrepresentation - Accountant misrepresents MATERIAL fact(s)
Scienter - Accountant commits scienter
Damages - Client has actual damages.
Reasonable Reliance - Client reasonably relied on the misinformation.
What is Scienter?
To report something knowing it is false.
Characterized by reckless disregard for truth
Intentionally conceal facts
What is the Accountant’s Liability to Third Parties - Privity Defense?
Lack of privity defends against contract breach and negligence.
NOT a defense against fraud.
The definition of Ultramares Decision:
Accountants are not liable to third parties unless the third party was an
intended beneficiary of the engagement AND the accountant knew they
would be relying on the financial statements.
What is Common Law Fraud?
Regular fraud
Misrepresentation of Material Fact
Scienter
Damages
Reasonable Reliance
What is Constructive Fraud?
Gross Negligence - reckless disregard for truth
CPAs usually not liable for simple negligence; but Gross Negligence (aka Constructive Fraud) opens the CPA up to be liable to third parties.
What are the required actions with Discovery of Illegal Activity?
Accountant must report discovered illegal activity to Audit Committee or Board of Directors
If material in public company; BOD has 1 DAY to notify SEC.
What is the Accountant-Client Privilege?
NO Federal Accountant-Client privilege for non-disclosure of private
conversations to a court unless a particular state recognizes such a privilege.
If your client tells you Yeah; I cheated on my taxes; a court could force an accountant to testify about that conversation.
Accountant’s Workpapers - Confidentiality Requirements
- Can be subpoenaed
- Can be looked at by another CPA doing peer review
- Property of the accountant who created them
Note: Source documents supplied by client must be returned to client if they request them back; even if there is a billing dispute.
True or False: Accountants are responsible for knowing the personal finances of tax preparation clients.
Accountants have no way of auditing individual’s personal finances and are not required to do so when preparing a return
When a past error is found in a client’s tax return; what should an accountant do?
If a past error is found; accountant should inform client of this error.
Contacting the IRS is NOT required.
If client won’t fix it; then the accountant should reconsider whether they want to do business with the client
Name the key responsibilities of an accountant when preparing a tax return.
Accountant must prepare the return in good faith and ask for more information if something is missing
When recommending a tax position; the accountant should realistically believe that it would stand up under the scrutiny of a court
What is Capital Budgeting? How is it used?
Managerial Accounting technique used to evaluate different investment options
Helps management make decisions
Uses both accounting and non-accounting information
Internal focus
GAAP is not mandatory
What values are used in Capital Budgeting?
Capital Budgeting ONLY uses Present Value tables.
Capital Budgeting NEVER uses Fair Value.
When is the Present Value of $1 table used?
For ONE payment- ONE time.
When is the Present Value of an Annuity Due used?
Multiple payments made over time- where the payments are made at the START of the period.
When is the Present Value of an Ordinary Annuity of $1 (PVOA) used?
Multiple payments over time- where payments are made at the END of the period.
Think A for Arrears.
What is the calculation for the Present Value of $1?
1 / (( 1+i )^n)
i : interest rate
n : number of periods
What is Net Present Value (NPV)?
A preferred method of evaluating profitability.
One of two methods that use the Time Value of Money
: PV of Future Cash Flows - Investment
How is NPV used to calculate future benefit?
NPV : PV Future Cash Flows - Investment
If NPV is Negative- Cost is greater than benefits (bad investment)
If NPV is Positive- Cost is less than benefit (good investment)
If NPV : 0- Cost : Benefit (Management is indifferent)
What is the rate of return on an investment called?
The Discount Rate.
What does the Discount Rate represent?
The rate of return on an investment used.
It represents the minimum rate of return required.
What are the strengths of the Net Present Value system?
Uses the Time Value of Money
Uses all cash flows- not just the cash flows to arrive at Payback
Takes risks into consideration
What are the weaknesses of the Net Present Value system?
Not as simple as the Accounting Rate of Return.
How do Salvage Value and Depreciation affect Net Present Value?
NPV includes Salvage Value because it is a future cash inflow.
NPV does NOT include depreciation because it is non-cash.
Exception - If a CPA Exam question says to include tax considerations- then you have to include depreciation because of income tax savings generated by depreciation.
If multiple potential rates of return are available- which is used to calculate Net Present Value?
The minimum rate of return is used.
What is the Internal Rate of Return (IRR)?
It calculates a project’s actual rate of return through the project’s expected cash flows.
IRR is the rate of return required for PV of future cash flows to EQUAL the investment.
Investment / After Tax Annual Cash Inflow : PV Factor
Which rate of return is used to re-invest cash flows for Internal Rate of Return?
Cash flows are re-invested at the rate of return earned by the original investment.
How does the rate used for Internal Rate of Return (IRR) compare to that used for Net Present Value (NPV)?
Rate of return for IRR is the rate earned by the investment.
Rate of return for NPV is the minimum rate.
What are the strengths and weaknesses of the Internal Rate of Return system?
Strengths: Uses Time Value of Money- Cash Flow emphasis
Weakness: Uneven cash flows lead to varied IRR
When is NPV on an Investment positive?
When the benefits are greater than the costs.
IRR is greater than the Discount Rate
When is NPV on an Investment Negative?
When Costs are greater than Benefits
IRR is less than the Discount Rate
When is NPV Zero?
When benefits equal the Costs
IRR : Discount Rate
What is the Payback Method? How is it calculated?
It measures an investment in terms of how long it takes to recoup the initial investment via Annual Cash Inflow
Investment / Annual Cash Inflow : Payback Method
Compare to a targeted timeframe; if payback is shorter than target- it’s a good investment. If payback is longer than target- it’s a bad investment.
What are the strengths of the Payback Method?
Takes risk into consideration
2 year payback is less risky than a 5 year payback
What are the weaknesses of the payback method?
Ignores the Time Value of Money
Exception: Discount payback method
Ignores cash flow after the initial investment is paid back
What is the Accounting Rate of Return?
An approximate rate of return on assets
ARR : Net Income / Average Investment
Compare to a targeted return rate; if ARR greater than target- good investment. If ARR less than target- bad investment.
What are the strengths of the Accounting Rate of Return (ARR)?
Simple to use
People understand easily
What are the weaknesses of the Accounting Rate of Return (ARR)?
Can be skewed based on Depreciation method that is used.
Ignores the Time Value of Money.
What is an Expected Return?
An approximate rate of return on assets.
What is the primary duty of the board of directors?
To monitor management behavior.
What is the responsibility of the Nominating or Corporate Governance Committee of the board of directors?
Oversees the board
Responsible for hiring new CEO
What is the responsibility of the audit committee of the board of directors?
The audit committee appoints and oversees the external auditor.
What is the duty of the compensation committee of the board of directors?
The compensation committee handles the CEO’s compensation package.
What does the NYSE and NASDAQ require of the board of directors?
They require the board to be independent.
What is the main goal in an executive compensation package?
The package should ensure that the goals of management should match those of the shareholders.
How can an executive compensation package ensure that goals of management align with those of shareholders?
Executive compensation should create an incentive for management to govern in a shareholder-friendly way that doesn’t sacrifice the long-term success of the enterprise for short-term gain.
Which influences help mold the direction that management takes?
They range from internal (Board of Directors- Audit Committee- Internal Control) to external (Creditors- SEC- IRS)
These influences should not be tainted by undue influence from management or have financial ties to management such as compensation-related duties
What is shirking?
When management doesn’t act in the best interest of shareholders.
It can be alleviated by tying compensation to stock performance or company profit.
What requirements are imposed on a public company under Sarbanes-Oxley?
Management must submit a report on the effectiveness of Internal Control in the 10K.
Management must disclose significant Internal Control deficiencies.
CEO/CFO must certify that the financial statements comply with securities laws and fairly present the financial condition of the company.
What characteristics are promoted by the COSO framework on Internal Control?
Reliable financial reporting
Effective and efficient operations
Compliance
What are the elements of the control environment?
Integrity & Ethics Competence The Board of Directors & Audit Committee Management's Operating Style Organizational Structure Authority & Roles of Responsibilities HR Policies
What are control activities?
A component of Internal Control that includes actions being taken to promote the control environment.
What are the basic elements of Internal Control?
Control Environment Risk Assessment Control Activities Information and Communication Monitoring
What is the significance of the Information and Communication aspect of Internal Control?
Management must have access to relevant and timely information to make good decisions.
How does Monitoring affect Internal Control?
Internal Control activities must be constantly monitored and evaluated for effectiveness.
What activities does the COSO framework for enterprise risk management include?
Identifies Risk Factors Promotes Risk Response Decisions Compares Management Risk vs. Shareholder Goals Aids in evaluating opportunities Promotes Quicker Capital movement
Does NOT eliminate all risk
What are possible responses to risk under the COSO framework for enterprise risk management?
Avoid or Reduce
Share or Accept
What is Cost Accounting?
Cost Accounting is a component of GAAP that records Ending Inventory on the Balance Sheet for
o Direct Materials
o Direct Labor
o Work in Process
o Finished Goods
Cost Accounting also records for the Income Statement
What is the difference between Cost Accounting and Managerial Accounting?
Cost Accounting - External Focus- GAAP
Managerial Accounting - Internal Focus- Not GAAP
What are Product Costs (aka Inventory Costs)?
Prime Costs
Conversion Costs
What are included in Prime Costs?
Direct Material USED - Have become part of the product or had a direct impact on the product
Direct Labor Used - Employees who worked on product and had direct impact
What is Factory Overhead?
All factory costs except for DM and DL used in production- including Spoilage (except for abnormal spoilage- which is a period cost and not included in OH).
What is included in Fixed Factory Overhead?
FFO : Estimated Costs / Normal Capacity
Uses Normal Activity
Examples of Fixed Factory OH: Depreciation (SL)- Utilities- Taxes
Under/Over-applied Fixed OH always goes to COGS
What is included in Variable Overhead?
VO : Estimated Activity / Actual Activity
Uses Actual Activity
Examples of Variable Factory OH: Deprecation (Units of Prod)- Indirect materials (supplies & insignificant items)- Indirect labor (factory foreman- janitors- machine maintenance)
Where is Under/Over-applied Variable OH recorded?
If Immaterial - Goes to COGS
If Material - Goes to WIP- Finished Goods- or COGS- based on their Ending Balance
Where is Under/Over-applied Fixed OH recorded?
It always goes to COGS
What is indicated by a Debit balance in Actual Factory Overhead? How is it corrected?
Under-applied overhead.
If it’s Fixed OH- under-applied goes to COGS.
If it’s Variable OH- under-applied goes to COGS if immaterial- but is allocated to WIP- FG or COGS based on ending balances.
What is indicated by a Credit balance in Applied Factory Overhead? How is it corrected?
A credit balance indicates over-applied overhead.
If Fixed overhead- it is corrected from COGS.
If Variable overhead- it is corrected through COGS if immaterial- but if material overage is allocated to WIP- FG or COGS based on ending balances.
Which variables are used to calculate Direct Material balances?
Beginning Balance DR Net purchases (plus freight-in)CR Direct Materials Used
: Ending balance (goes to BS)
What variables are used to calculated Work in Process (WIP)?
Beginning Balance (End Bal of Previous WIP)DR Direct Materials UsedDR Direct Labor Used (Conversion Cost)CR COGMDR Factory Overhead Applied (Conversion Cost)
: Ending Balance (Goes to BS)
What variables are included in Finished Goods calculations?
Beginning BalanceDR COGM
: COGAS (Cost of Goods Avail for Sale)
CR COGS
: Ending Balance (Goes to BS)
How does Freight In affect Cost Accounting calculations?
Inventory (Product) Cost
Part of DM Purchases
How does Freight Out affect Cost Accounting?
Selling (Period) Cost
Not part of inventory
When is Job-Order Costing used?
Used when costs are easily connected to a specific product or product line
Can also be applied to services
Calculation is the same as normal cost accounting - just use your T Accounts
- DM to WIP to FG to COGS
- You’re likely going to be solving for the last job in the queue
What is the Direct Method for allocating service department costs?
No services allocated between service departments- even if they serve each other. Only allocate to product(s)
What is the Step Method for allocating service department costs?
Services can be allocated to both other service departments and the product(s)
Under process costing- how are the units shipped calculated?
Beginning Inventory+ Units Started- Ending Inventory
: No. Units Shipped
Which two inventory methods are used under Process Costing?
FIFO
Weighted Average
What is another name for Process Costing?
Equivalent Units of Production
How will Equivalent Finished Units under FIFO compare to EFU under the Weighted Average method?
EFU FIFO will always be LESS than EFU Weighted Avg (unless Beginning Inventory is Zero)
How are Direct Materials calculated under the Weighted Average Method?
Beginning Inventory + Current Costs / EFU WA
How are Conversion Costs calculated under Weighted Average Method?
Beginning Inventory + Current Costs / EFU WA
How are Equivalent Finished Units calculated for Direct Materials?
Units Shipped + EI x % Complete DM
: EFU (Weighted Average Method)
- Beginning Inventory x % Complete
: EFU (FIFO)
How are Equivalent Finished Units calculated for Conversion Costs?
Units Shipped+ EI x % Complete CC
: EFU (Weighted Average)
- Beginning Inventory x % Complete
: EFU (FIFO)
How are Direct Materials calculated under the FIFO method?
Current Costs / EFU FIFO
Note: FIFO method uses Current Period costs only and ignores Beginning Inventory
How are Conversion Costs calculated under the FIFO method?
Current Costs / EFU FIFO
FIFO method uses Current Period costs only and ignores Beginning Inventory
How is WIP calculated?
Beginning balance (DM- DL- OH)+ Current Costs (DM- DL- OH)- COGM (Goes to Finished Goods)+ DM EFU x Cost per DM EFU+ CC EFU x Cost per CC EFU
: Ending WIP
How do period costs and product costs relate to net sales- gross margin and operating income?
Net Sales - Product Costs
: Gross Margin
- Period Costs
: Operating Income
What is the focus of Activity Based Costing (ABC)?
Focuses on eliminating non-value-added activities for poor quality and inventory and things customers don’t want or don’t care about
Inventory is expensive to store and storing something is not a value-added expenditure
Uses Cost Pools - Different departments can have different OH rates
Uses Several OH rates based on Activity - Cost Pool / Cost Driver
How do Cost Pools and Allocations compare under ABC versus traditional costing system?
Cost Pools and Allocations increase compared to a traditional costing system
What is Backflush Costing?
Connected to Just-in-Time Production- which is part of Activity-Based Costing and Total Quality Management (TQM)
- Works backward to flush out COGS
- Mostly GAAP
What are the characteristics of By-Products?
Usually immaterial and common costs aren’t allocated to them
Low Market Value
Can be valued at NRV
Can be treated as a contra expense and netted against COGS - Can be treated as a contra sale and netted against Sales
Recognition rules are very flexible with valuing and classifying by-products
What are Cost Functions?
Measure how costs change relative to activity levels
High-Low Method
Change in Cost (High-Low pts) / Change in Activity (High-Low pts)
How does a price increase affect supply?
When the prices of an item increases supply increases- because more sellers are willing to sell.
What is a supply curve shift?
When supply changes due to something other than price.
What are the characteristics of a positive supply curve shift (shift right)?
Supply increases at each price point
Higher Equilibrium GDP
Number of sellers increases - market can get flooded
Examples: Government subsidies or technology improvements that decrease costs for suppliers
What are the characteristics of a negative supply curve shift (shift left)?
Supply decreases at each price point
Lower Equilibrium GDP
Cost of producing item increases
Examples: Shortage of gold- so less gold watches are made; wars or crises in rice-producing countries means there is less rice on the market
How does price affect the demand for an item?
When the prices of an item increases- demand for it decreases.
What is a Demand Curve Shift?
When demand changes due to something other than price.
What is a Positive Demand Curve Shift (Shift Right)?
When demand increases at each price point
Price of substitutes go up - price of beef rises- so people buy more chicken
Future price increase is expected - War in Middle East- people go out and buy gas
Market expands - i.e. people get new free health care plan- demand at clinic rises
Expansion - more spending increases equilibrium GDP
What is a Negative Demand Curve Shift (Shift Left)?
Demand decreases at each price point.
Price of complement goes up - price of beef goes up- less demand for ketchup
Boycott - Company commits social blunder- consumers boycott
Consumer income rises - Demand for inferior goods drops as people have more money to spend
Consumer tastes change
Contraction - less spending decreases equilibrium GDP
What is the Marginal Propensity to Consume?
How much you spend when your income increases
Calculate: Change in Spending / Change in Income
What is the Marginal Propensity to Save?
How much you save when income increases
Calculate: Change in Savings / Change in Income
Also equals 1 - Marginal Propensity to Consume
How is the multiplier effect calculated?
(1 / 1-MPC) x Change in Spending
How does increased spending by consumers and the government affect the demand curve?
As spending by consumers or the government increases- the demand curve increases (shifts right).
How does spending change due to the multiplier effect?
The increase in demand ends up being larger than the amount of additional income spent in the economy due to the multiplier effect.
One consumer spends money- which:
*Increases the income of a business
*Increases the income of a vendor
*Increases income of employees
*Increases tax revenue
How is Price Elasticity of Demand calculated?
% Change in Quantity Demand / % Change in Price
Under elastic demand- how does price affect revenues?
Price increases- Revenue decreases
Price decreases- Revenue increases
What conditions would indicate Elastic Demand?
Many substitutes (luxury items)
Considered elastic if elasticity is greater than 1
10% drop in demand / 8% increase in price : 1.25 (Elastic)
Price increases- Revenue decreases
Price decreases- Revenue increases
How does revenue react to price under Inelastic Demand?
Price increases- Revenue increases
Price decreases- Revenue decreases
What conditions would indicate Inelastic Demand?
Few substitutes (groceries- gasoline)
Considered inelastic if coefficient of elasticity is less than 1
5% drop in demand / 10% increase in price : .5 (inelastic)
Price increases- Revenue increases
Price decreases- Revenue decreases
What is Unitary Demand?
Total revenue will remain the same if price is increased
Considered unitary if coefficient of elasticity : 1
How is Income Elasticity of Demand calculated?
% Change Quantity Demanded / % Change in Income
Normal goods greater than 1 (demand increases more than income)
Inferior goods less than 1 (demand increases less than income)
What conditions occur under periods of inflation?
Interest rates increase
Reduced demand for loans
Reduced demand for houses- autos- etc.
Value of bonds and fixed income securities decrease
Inferior good demand to increase
Foreign goods more affordable than domestic
Demand for domestic goods decrease
What happens under Demand-Pull inflation?
Overall spending increases
Demand increases (shifts right)
Market equilibrium price increases
What happens under Cost-Push inflation?
Overall production costs increase
Supply decreases (shifts left)
Market equilibrium price increases
Note: Demand-Pull and Cost-Push Inflation BOTH result in market equilibrium price to increase
What is the Equilibrium Price?
The price where Quantity Supplied : Quantity Demanded
What is Optimal Production?
When Marginal Revenue : Marginal Cost
What is the result of a Price Floor?
Causes a surplus if above equilibrium price.
What is GDP (Gross Domestic Product)?
The annual value of all goods and services produced domestically at current prices by consumers- businesses- the government- and foreign companies with domestic interests
Included: Foreign company has US Factory
Not included: US company has foreign factory
What is included under the income approach for calculating GDP?
Sole Proprietor and Corp Income
Passive Income
Taxes
Employee Salaries
Foreign Income Adjustments
Depreciation
What is included under the Expenditure Approach for calculating GDP?
Individual Consumption
Private Investment
Government Purchases
Net Exports
What is Nominal GDP?
Measures goods/services in current prices.
For what is a GDP Deflator used?
Used to convert GDP to Real GDP
What is Real GDP?
Nominal GDP / GDP Deflator x 100
What is Gross National Product (GNP)?
Like GDP; Swaps foreign production. US Firms overseas are included- Foreign firms domestically are not included
What is the Consumer Price Index (CPI)? How is it applied?
Price of goods relative to an earlier period of time- which is the benchmark. Year 1 : 1.0
((CPI Current - CPI Last) / CPI Last) * 100
How is disposable income calculated?
Personal Income - Personal Taxes
How is Return to Scale calculated?
% Increase in output / % Increase in input
Greater than 1 : Increasing returns to scale
Less than 1 : Decreasing returns to scale
When is the economy in Recession?
When GDP growth is negative for two consecutive quarters.
What is a Depression?
A prolonged- severe recession with high unemployment rates
No requisite period of time for the economy to officially be in a depression
What are the stages of the Economic Cycle?
Peak (highest)
Recession (decreasing)
Trough (lowest)
Recover (increasing)
Expansion (higher again)
What are leading indicators?
Conditions that occur before a recession or before a recovery
Example: Stock Market or New Housing Starts
What are lagging indicators?
Conditions that occur after a recession or after a recovery
Examples: Prime Interest Rates- Unemployment
What are coincident indicators?
Conditions that occur during a recession or during a recovery
Example: Manufacturing output
Which people are included in the calculation of unemployment?
Only people looking for jobs
What is Cyclical Unemployment?
GDP doesn’t grow fast enough to employ all people who are looking for work
Example: People are unemployed in 2010 because there aren’t enough jobs available due to the economy
What is Frictional Unemployment?
People are changing jobs or entering the work force. This is a normal aspect of full employment.
Example: A recent college graduate is looking for a job
What is Structural Unemployment?
A worker’s job skills do not match those necessary to get a job so they need education or training
Example: A construction worker wants to work in an office- so they quit their job and get computer training
How does inflation relate to unemployment?
High Unemployment : Low Inflation (Vice Versa)
What is the Discount Rate?
The rate a bank pays to borrow from the Fed.
What is the Prime Rate?
The rate a bank charges their best customers on short-term borrowings.
What is the Real Interest Rate?
Inflation-adjusted interest rate
What is the Nominal Rate?
Rate that uses current prices
What is the Risk-Free Rate?
Rate for a loan with 100% certainty of payback.
Usually results in a lower rate.
US Treasuries are an example.
What is included in the M1 money supply?
Currency- Coins- and Deposits
What is included in the M2 money supply?
Highly liquid assets other than currency- coins or deposits
What is Deficit Spending?
Increased spending levels without increased tax revenue.
Lower taxes without decrease in spending
Gamble that the multiplier effect will take over and boost economy
How can the Fed control the money supply?
By buying and selling the government’s securities.
How does the Fed control economy-wide interest rates?
By adjusting the discount rate charged to banks
What is a Tariff?
A tax on imported goods
What is a quota?
A limit on the number of goods that can be imported
How do international trade restrictions affect domestic producers?
They are good for domestic producers.
Demand curve shifts right
Fewer substitutes
They can charge higher prices
How to international trade restrictions affect foreign producers?
They are bad for foreign producers
Demand curve shifts left
Fewer buyers
They must charge lower prices
How do international trade restrictions affect foreign consumers?
They are good for foreign consumers
Supply curve shifts right
Goods purchased at lower prices in the foreign markets
How do international trade restrictions affect domestic consumers?
They are bad for domestic consumers
Supply curve shifts left
Fewer goods bought due to higher prices
What is Accounting Cost?
Explicit (Actual) cost of operating a business
Implicit costs are opportunity costs
What is Accounting Profit?
Revenue - Accounting Cost
What is Economic Cost?
Explicit + Implicit Cost
What is Economic Profit?
Revenue - Economic Cost
What is the primary focus of working capital management?
Managing inventory & receivables (current assets & liabilities)
How is Net Working Capital calculated?
NWC : Current Assets - Current Liabilities
What are the characteristics of effective Working Capital Management?
Shorten the cash conversion cycle
Don’t negatively impact operations
What is the Inventory Conversion Period?
Average time needed to convert materials into finished goods and sell them
Average Inventory : (BI + E) / 2
Inventory Conversion Period : Average Inventory / Sales Per Day
What is the Receivables Collection Period?
Average time needed to collect A/R
RCP : Average Receivables / Credit Sales Per Day
What is the Payables Deferral Period?
Average time between materials and labor purchase and their A/P payment
Average Payables : (BP + EP) / 2
Payables Deferral Period : Average Payables / (COGS/365)
What is the Cash Conversion Cycle?
Amount of time it takes to receive a cash inflow (Customers) after making a cash outflow (Vendors)
Inventory Conversion Period
+ Receivables Collection Period
- Payables Deferral Period
: Cash Conversion Cycle
(Inventory Really (-Pays) Cash)
What traits should Cash and Short-Term Investments have?
Liquid
Safe
For what are Letters of Credit used?
Used for importing goods.
Issued by importer’s bank.
What is the advantage of using Trade Credit?
No interest cost if paid timely.
What is a Lockbox System? What are the advantages?
Customer Payments are sent to a bank-managed PO box.
Employees don’t have access to cash.
Deposits are more timely.
Interest income from deposits should pay for the Lockbox fees (if they don’t- lockbox is not beneficial)
What is float?
Time it takes to mail a payment and have it clear your bank account
Maximize float on cash payments
Minimize float on cash receipts
What are Zero Balance Accounts?
Regional bank sends enough cash to cover daily checks
Advantages:
Checks take longer to clear -more float
Low amounts of cash tied up for compensating (minimum) balances
What is the difference between Treasury Bills- Notes and Bonds?
Treasury Bills: Short term (less than one year) Think: $1 Bill
Treasury Notes: Medium term (less than 10 years- more than 1)
Treasury Bonds: Long term (greater than 10 years) Think: government is in long-term bondage to you; they owe you money
What is commercial paper?
Similar to T-Bill- but issued by corporations instead of Government
Greater than 9 Months Maturity
Unsecured
Issued by large firms
What are the advantages and disadvantages of Commercial Paper?
Advantages: Financing at less than Prime. No compensating balances required.
Disadvantages: Unpredictability of markets. Credit crisis emerges and large insurance/investment companies aren’t lending.
What is Economic Order Quantity?
The order quantity that minimizes inventory costs.
EOQ : Square Root of (2DO/C)
D : Unit Demand (Annual)
O : Order Cost
C : Cost of Inventory
What is Carrying Cost?
The cost of keeping inventory.
What is Order Cost?
Cost of executing an order and starting product production.
What is inventory reorder point?
How low inventory should get before it should be re-ordered.
IOP : Average Daily Demand x Average Lead Time
What is a Just In Time (JIT) system?
Orders inventory so that you get it just in time for when it’s needed
JIT is valuable when Order Cost is low and Cost of Carrying Inventory is high
What is Factoring of receivables?
Receivables are sold to a financing company where they pay less than the value of the receivables due to a discount related to risk of non-collection
What is a Trade Discount?
Buyer saves if paid early
Example: 1/10 Net 30
1% Discount if paid within 10 days
If not- bill is still due in 30 days
What is the cost of forgoing a discount?
(Discount % x 365) / ((100% - Discount) x (Pay Period - Discount Period))
What is the Prime Rate?
A benchmark used for lending only to the best customers
Most customers will be charged Prime + 3%- for example
If the lending institution and the customer are not in the same country- the LIBOR rate is often used
What is the Nominal (Face- Coupon- Stated) Rate?
Interest rate stated on the face of a bond.
How is Current Yield calculated?
CY : Interest Payment / Bond Price
What is the Effective (YTM- Market) Rate?
PV of Principle + Interest : Bond Price
What is a Zero Coupon Bond?
No interest payments made
Bond sold at a discount
Interest reflected when Bond matures
What are the characteristics of a Junk Bond?
High interest rate
High default risk
What are debenture bonds?
Bonds unsecured by collateral
What are subordinated debentures?
Debenture Bonds that will be repaid if any assets are left after liquidation of a company
What are Redeemable Bonds?
Provision in Bond contract allows demand of Bond payment under certain circumstances
What is a Callable Bond?
Borrower can pay off debt early
What is a Convertible Bond?
Lender can demand payment via company stock instead of money
What is a Sinking Fund?
Borrower deposits regular sums into an account that will eventually pay off the debt
What is the disadvantage of Common Stock in comparison to bonds?
Common Stock is more expensive to issue than debt.
Why? Investors demand a greater ROI than debtors (bondholders)
What is the advantage of Preferred Stock?
Hold dividend priority over common stock
What is Weighted Average Cost of Capital?
A company uses this to determine the true cost of their capital
Example: Debt costs 5%; 40% of Cap. Equity costs 12%; 60% of Cap. (5% x 40%) + (12% x 60%) WACC : 9.2%
What is CAPM?
A stock’s expected performance is based on its beta (risk) compared to that of the stock market.
More risk : more expected return.
How is Cost of Debt calculated?
(Interest Expense - Tax Benefit) / Carrying Value of Debt
What is a Static Budget?
Budget targeted for a specific segment of a company.
What is a Maser Budget?
Budget targeted for the company as a whole
Includes budgets for Operations and Cash Flows
Includes set of budgeted Financial Statements
How do Fixed Costs affect budgeting?
Costs independent of the level activity within the relevant range
Property Tax is the same whether you produce 100-000 units or zero units
However - Fixed Costs per unit vary given the amount of activity
If you produce fewer units- fixed costs per unit will be greater than if you produce more units - i.e. less units to spread the cost over
How do Variable Costs affect budgeting?
The more Direct Materials or Direct Labor used- the more Variable Costs per unit
However - Variable Costs per unit don’t change with the level of activity like Fixed Costs per unit
How are Material Variances calculated?
SAM:
Standard Material Costs
- Actual Material Costs
= Material Variance
How are Labor Variances calculated?
SAL
Standard Labor Costs
- Actual Labor Costs
= Labor Variance
How are Overhead Variances calculated?
OAT
Overhead Applied
- Actual Overhead Cost
= Total Overhead Variance
How does Absorption Costing compare to Variable Costing?
Absorption Costing - External Use- Cost of Sales- Gross Profit- SG&A
Variable Costing - Internal Use- Variable Costs- Contribution Margin- Fixed Costs
How is Contribution Margin calculated?
Sales Price (per unit)
- Variable Cost (per unit)
= Contribution Margin (per unit)
How is Break-even Point (per unit) calculated?
Total Fixed Costs / Contribution Margin (per unit)
= Break-even Point Per Unit
Assumption: Total Costs & Total Revenues are LINEAR
