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AUDIT > AUDIT 3 > Flashcards

AUDIT 3 Flashcards

1
Q

What is the difference between error and fraud?

State the auditor’s responsibility to detect errors and fraud.

A

Error is unintentional, fraud is intentional with the intent to deceive FS users by having misstatements or omissions.

The auditor must plan and perform the audit (using due care and professional skepticism) to provide reasonable assurance (not absolute) about whether the FS are free of material misstatement, whether due to errors or fraud.

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2
Q

Name two types of fraud.

A
  1. Fraudulent FR

2. Misappropriation of assets or defalcation

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3
Q

What fraud risk factors are generally present when fraud occurs?

A

These 3 conditions are typically present:

  1. Incentives/pressure
  2. Opportunity
  3. Rationalization/attitude

We identify these risk factors as a part of assessing risk of MM due to fraud.

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4
Q

When analyzing fraud risk, which four attributes should the auditor consider?

A

Type of risk, significance, likelihood, pervasiveness

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5
Q

Distinguish between the 3 types of MM

A
  1. Factual misstatements: There is no doubt it is wrong.
  2. Judgemental: Mgt. and the auditor have material differences on accounting estimates or the application of accounting principles.
  3. Projected misstatements: Represents the auditor’s best estimate of msistatements in populations, by projecting misstatements in an audit sample to the population from which the samples were drawn.
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6
Q

What is audit risk? List and define the two elements of audit risk.

A

Audit risk is the risk that the auditor may unknowingly fail to modify appropriately the opinion on FS that are materially misstated. It compromises:

  1. Risk of MM: The risk that the FS are wrong.
  2. Detection risk: Risk that the auditor will not detect a material misstatement that exists in a relevant assertion.
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7
Q

Provide some examples of factors that would increase inherent risk.

A
  1. Technological developments that make products obsolete
  2. A lack of working capital
  3. A decline in overall industry or economy
  4. High-Volume Transactions
  5. Complex transactions
  6. Amounts derived from estimates
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8
Q

2 components of risk of MM.

A
  1. Inherent risk: The susceptibility of a relevant assertion to a material misstatement assuming there are no related controls.
  2. Control Risk: The risk that a MM that could occur in a relevant assertion will not be prevented or detected (and corrected) on a timely basis by the entity’s internal control.
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9
Q

State the audit risk model, including the relationship of detection risk to substantive tests.

A

AR = RMM (IR x CR) x DR

There is an inverse relationship between RMM and DR. As the acceptable level of DR increases, the required assurance from substantive tests decreases. As the acceptable level of DR decreases, the assurance required from substantive testing must increase.

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10
Q

How may the auditor obtain more assurance from substantive procedures?

A
  1. Changing the nature of the substantive tests from less effective to more effective (reaching out directly to outside parties)
  2. Changing the extent (larger sample sizes)
  3. Changing the timing (Performing a year-end rather than interim)
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11
Q

What are the 3 ways an auditor should respond to assessed risk?

A
  1. An overall response, to address risk at the FS level.
  2. A response at the relevant assertion level
  3. A response to significant risks
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12
Q

What is a significant risk?

A

A significant risks is one that requires special audit consideration.

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13
Q

What are the documentation requirements surrounding the auditor’s assessment of risk?

A
  1. Discussion among the audit team
  2. Understanding of the entity and its environment, including its internal control.
  3. Assessment of the risks of MM
  4. Basis for the risk assessment
  5. Identified risks and related controls evaluated
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14
Q

What should be included in each step of the audit plan? (Casting our NET over the audit)

A

Set out the procedure in detail, specifying the nature, extent, and timing of the work to be performed and indicating a reference to the assertion under consideration.

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15
Q

How does the auditor’s assessment of the risk of MM affect substantive procedures?

A
  1. When it is high, it necessitates a greater level of assurance from substantive tests.
  2. When low, reduce the assurance required through substantive tests.
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16
Q

What are the two approaches an auditor may use to respond to identified risks at the relevant assertion level?

A
  1. Substantive approach: Only substantive tests are used, either because there are no effective controls, or because it would not be efficient to test the operating effectiveness of controls.
  2. Combined approach: Tests of the operating effectiveness of control and tests of substantive procedures are both used.
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17
Q

What are tests of controls performed in a financial statement audit?

A

When the auditor’s risk assessment is based on the assumption that controls are operating effectivelly OR when substantive procedures alone are insufficient, such as when there is a sig. amount of electronic processing.

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18
Q

What steps should the auditor perform in assessing and responding to risk?

A
  1. Obtain an understanding of the entity and its environment, including its internal control.
  2. Assess the risk of MM.
  3. Respond to the assessed level of risk by designing further audit procedures based on this assessment.
  4. Test internal controls to evaluate their operating effectiveness.
  5. Perform substantive tests.
  6. Evaluate the sufficiency and appropriateness of audit evidence obtained.
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19
Q

What are some common audit procedures related to contingencies, including pending litigation or possible future litigation?

A
  1. Obtaining and reviewing the response from a letter of inquiry to the client’s attorneys.
  2. Inquiring of management
  3. Reviewing minutes of meetings of stockholders, board of directors, and other executive members.
  4. Reviewing correspondence and invoices from lawyers.
  5. Reviewing contracts, loan agreements, leases, and correspondence from taxing authorities.
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20
Q

Define related parties.

A

These may include the reporting entity’s affiliates, principal owners, and management, as well as any members of their immediate families.

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21
Q

How can the auditor determine whether related parties existed?

A
  1. Evaluating the company’s procedures for identifying and accounting for related party transactions.
  2. Asking management
  3. Reviewing the reporting entity’s filings with the SEC
  4. Reviewing material transaction for related party evidence
  5. Reviewing prior year’s audit documentation or inquiring of the predecessor auditor.
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22
Q

What is the auditor’s primary concern with respect to related party transactions?

A

We are concerned with the proper disclosure of related party transactions in accordance with GAAP.

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23
Q

List the three types of audit procedures and tell why each is used.

A
  1. Risk assessment procedures: To obtain an understanding of the entity and its environment, including its internal control.
  2. Tests of controls: To evaluate the operating effectiveness of internal control in preventing or detecting material misstatements.
  3. Substantive procedures: To detect material misstatements in the financial statements.
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24
Q

When is audit evidence gathered during an audit?

A

When performing:

  1. Risk assessment procedures
  2. Tests of controls
  3. Substantive procedures
  4. Other audit procedures
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25
Q

What influences the auditor’s decision regarding the sufficiency of evidential matter?

A
  1. The risk of material misstatement

2. The quality of audit evidence

26
Q

What factors should be considered when evaluating the reliability of audit evidence?

A
  1. Auditor’s direct personal knowledge, evidence from outside sources, documentary evidence, consistency is beter
27
Q

How is the relevance of evidence determined?

A

To be relevant, evidence must relate to the FS assertions under consideration.

PCAOB standards state that the relevance of audit evidence depends on the design and timing of the audit procedure.

28
Q

What are the documentation requirements surrounding the auditor’s response to assessed risk.

A
  1. Document the overall response addressing assessed risk at the FS level.
  2. NET of further audit procedures.
  3. Linkage of further audit procedures with assessed risk at the relevant assertion level.
  4. Results of audit procedures.
  5. Conclusions reached regarding the use of prior period evidence.
29
Q

What factors are relevant to the conclusion that sufficient appropriate evidence has been obtained?

A
  1. The significance of uncorrected misstatements and the likelihood of their having a material effect on the FS.
  2. The results of audit procedures performed.
  3. The auditor’s risk assessment.
  4. The appropriateness of the evidence obtained.
30
Q

List some of the standard auditing procedures used in most audits. (C the FIVE CARROT WARS)

A
  1. Confirmation
  2. Footing
  3. Inquiry
  4. Vouching
  5. Examination, Inspection
  6. Cutoff Review
  7. Analytical Procedures
  8. Reperformance
  9. Reconciliation
  10. Observation
  11. Tracing
  12. Walk-Through
  13. Auditing related accounts simultaneously
  14. Rep. Letter
  15. Subsequent events review
31
Q

What are analytical procedures?

A
  1. Evaluations of financial information made by study of plausible relationships among both financial and nonfinancial data.

Note: Analytical proc. are required in the planning and final review phases of the audit. They can also be used (but are not required) in substantive testing.

32
Q

What steps are involved when using analytical procedures for substantive testing?

A
  1. Determine the analytical procedures are suitable for testing the assertions.
  2. Evaluate the reliability of data from which the auditor’s expectation is to be developed.
  3. Develop an expectation of the recorded amount.
  4. Compare the actual versus expected.
  5. Investigate any significant differences.
33
Q

What is the purpose of applying analytical procedures during the overall review stage of the audit?

A

To evaluate the overall financial statement presentation, to assess the conclusions reached, and to assist in forming an opinion on whether the financial statements are free of material misstatement. This evaluation is typically performed by the manager or partner.

34
Q

What should be the direction of testing if the auditor is concerned about the existence or occurrence assertion?

A

Vouching backward from the accounting records (FS, JE) to source documents provides evidence of existence or occurrence.

35
Q

What should be the direction of testing if the auditor is concerned about the completeness assertion?

A

Tracing forward from source documents to the accounting records (FS, JE) provides evidence of completeness.

36
Q

What are the types of financial ratios?

A

Liquidity ratios: Measure short-term ability to pay obligations

Activity ratios: Measure effective use of assets

Profitability ratios: Measure the financial performance of an entity

Investor Ratios: Measure performance and market-based metrics

Coverage ratios: Measure security for long-term creditors/investors

37
Q

What are some limitations of using financial ratios?

A

Although ratios are useful, they have the following limitations.

  1. Few industry benchmarks exist for comparison.
  2. Dissimilar business units make analysis difficult.
  3. Management may manipulate financial data and ratios.
  4. Inflation can reduce comparability of balance sheet items.
  5. The choice or change in accounting principles can affect ratios and reduce comparability.
38
Q

How are the current ratio and quick ratio calculated?

A

Current ratio = current assets/current liabilities

Quick ratio = (Cash and cash equivalents + short-term marketable securities + receivables (net) ) / Current Liabilities

39
Q

How are the accounts receivable turnover and inventory turnover calculated?

A

Accounts Receivable Turnover = Sales(Net)/ Average Accounts Receivable (Net)

Inventory Turnover = COGS/ Average Inventory

40
Q

How are the profit margin and the return on assets calculated?

A

Profit Margin = Net Income/Sales (net)

Return on assets = Net income/Average Total Assets

41
Q

How are earnings per share (EPS) and the price/earnings (P/E) ratio calculated?

A

Basic EPS: (Income available to common shareholders)/(Weighted average common shares outstanding)

P/E Ratio = (Price per share)/(Basic earnings per share)

42
Q

How are the debt-to-equity ratio, the total debt ratio, and times interest earned calculated?

A

Debt to Equity = Total Liabilities/Total Equity

Total Debt Ratio = Total Liabilities/Total Assets

Times Interest Earned = Earnings before interest expense and taxes/Interest Expense

43
Q

What is the difference between non-statistical and statistical sampling?

A

Statistical Sampling:

  1. Uses law of probability for selection and evaluation of a sample
  2. Allows for quantification of audit risk and sufficiency of audit evidence

Non-Statistical Sampling:

  1. Does not utilize statistical models in calculations
  2. Auditors use their judgement to determine sample sizes and sample results are evaluated using auditor judgement
44
Q

When is professional judgement necessary in the use of statistical or non-statistical sampling by an auditor?

A

An auditor must use professional judgement to:

  1. Define the population and sampling unit
  2. Select the appropriate sampling method
  3. Evaluate whether the audit evidence is appropriate
  4. Evaluate the nature of deviations or errors
  5. Consider sampling risk
  6. Evaluate sample results and project to the population
45
Q

Define Sampling Risk.

A

It is the risk that the auditor’s conclusion based on a sample is different from the conclusion that would have been reached if the tests had been applied to all items in the population.

46
Q

Identify 2 aspects of sampling risk that the auditor would be concerned with when performing substantive testing.

A

Risk of incorrect acceptance or risk of incorrect rejection

47
Q

Define the 2 aspects of sampling risk for test of controls

A
  1. Risk of assessing control risk is too low (Deciding that the control is more effective/reliable than it really is; affects audit effectiveness)
  2. Risk of assessing control risk too high (Deciding that the control is less effective/reliable than it really is, affects audit efficiency)
48
Q

What is the relationship between sampling risk and reliability (confidence level)?

A

Sampling risk + confidence level = 100%

49
Q

What is attribute sampling?

A

It is a statistical sampling method used to estimate a rate of occurrence in a sample. It is used in test of controls.

50
Q

What factors affect sample size for an attribute sampling application?

A

The following factors affect sample size in an attribute sampling application

  1. Risk of it being too low
  2. Tolerable deviation rate
  3. Expected Deviation Rate
  4. Population Size (Not an issue if population size is large)
51
Q

What rates are compared in drawing a conclusion about an attribute sampling application?

A

We compare the upper deviation rate with the tolerable deviation rate in drawing conclusions. If the upper deviation rate exceeds the tolerable rate, the audit will NOT rely on the control. (Upper deviation rate is the sample deviation plus the allowance for sampling risk)

52
Q

What is discovery sampling?

A

It is a type of attribute sampling used when the expected deviation rate is zero or near zero. It is used when the auditor is looking for a very critical characteristic (ie. fraud).

53
Q

Define tolerable deviation rate (for attribute sampling) and tolerable misstatement (for variables sampling).

A

Tolerable deviation rate: The maximum % of deviation from a control procedure that the auditor is willing to accept while still relying on the control.

Tolerable misstatement: The largest amount of misstatement that the auditor believes can exist in a balance or class of transactions without causing the financial statements to be materially misstated.

54
Q

What factors affect sample size for a variables sampling application?

A
  1. Deviation
  2. Tolerable misstaement
  3. Acceptable level of risk
  4. Expected size and frequency of misstatements
  5. Assessed level of risk
55
Q

Describe variables sampling.

A

It is a statistical sampling method used to estimate the numerical amount of a population. Variable sampling is used primarily in substantive testing.

56
Q

What is stratification and why would an auditor stratify a population?

A

Stratification seperates the sample into relatively homogeneous groups. Each group is treated as a different population.

Stratification is typically used when a population has a highly variable amounts. Stratification usually results in a smaller sample size.

57
Q

What amounts are compared in drawing a conclusion about a variables sampling application.

A

The auditor compares the client’s book value to the calcilated range in a variable sampling application. If the recorded book value is within the acceptable range, the book value is considered fairly stated. (The calculated range is the point estimate, as determined from the sample, plus/minus an allowance for sampling risk).

58
Q

What are the sampling plans commonly used for variables estimation?

A
  1. Mean-per-unit estimation: The sample mean is multiplied by the number of items in the population to estimate population value.
  2. Ratio Estimation: The ratio between book value and audited value (from a sample) is used to estimate population value.
  3. Difference estimation: The difference between book value and audited value (from a sample) is used to estimate population value.
59
Q

Define probability-proportional-to-size (PPS) sampling.

A

This is a hybrid sampling method technique that uses attribute sampling theory to express a conclusion in dollar amounts rather than as a rate of occurrence. The sampling unit is defined as an individual dollar in a population, which creates the effect of stratified sampling (the unit’s chance of being selected increases as its amount increases).

60
Q

What are the advantages and disadvantages of using PPS sampling?

A

Advantages: Automatic stratification, efficient (smaller sample)

Disadvantages: May require special considerations for negative, zero, and understated balances

61
Q

How is the sampling interval determined in PPS sampling application?

A

Sampling interval = Tolerable misstatement/ Reliability Factor

*The reliability factor comes from a table and is based on the risk of incorrect acceptance.

62
Q

How is the sample size determined in a PPS sampling application?

A

Sample Size = (Recorded Amount of the population)/Sampling Interval

AUDIT (6 decks)

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