Audit & Assurance exam

Question 1

Distinguish between reasonable assurance and limited assurance

Answer 1

Reasonable assurance engagements aim at reducing risk to an acceptably low level as a basis for a positive conclusion (reasonable assurance means a high but not absolute level of assurance).

Limited assurance engagements aim at reducing risk to a level that is acceptable in the circumstances but where that risk is greater than for a reasonable assurance engagement as the basis for a negative conclusion.

Question 2

Why is there a demand for audits?

Answer 2

Agency theory
Information hypothesis
Insurance hypothesis
Regulation

Question 3

Steps in accepting an audit engagement

Answer 3

CLIENT EVALUATION
Evaluate integrity of management
Identify special circumstances and unusual
risks

ETHICAL AND LEGAL CONSIDERATIONS

• Evaluate independence
• Assess competence to perform audit
• Determine ability to use due care

ENGAGEMENT
Prepare engagement letter

Question 4

Internal control system

Five components:

Answer 4

Control environment
Risk assessment processes
Information system
Control activities
Monitoring of controls.

Question 5

What is an audit?

Answer 5

“A systematic process of objectively obtaining and evaluating evidence regarding assertions made about economic actions and events to ascertain the degree of correspondence between those assertions and established criteria and communicating the results to interested users”

                               American Accounting Association (1973)

Question 6

The audit expectation gap

Answer 6

“the difference between what auditors actually do when they conduct an audit and what shareholders and others think auditor’s do, or should do, in conducting the audit”

                                   Report of HIH Royal Commission

Question 7

What is governance?

Answer 7

The exercise of economic and administrative authority to manage an entity’s affairs.
Concerned with processes by which decisions are made and implemented, so that the entity’s affairs are conducted properly and in accordance with the laws and other applicable regulations.
Applicable to all entities.

Question 8

The auditor and governance

Answer 8

Overall objective of the auditor:
“ …to obtain reasonable assurance about whether
the financial report as a whole is free from
material misstatement, whether due to fraud or
error…” (ASA200.11)
The effectiveness of the assurance engagement is a function of the auditor’s relationship with the entity’s management and the governance body.

Question 9

Internal auditing

Answer 9

Internal audit encompasses examination and evaluation of:
Adequacy and effectiveness of governance and internal control structure.
The quality of performance.
The procedures of risk identification and management
Mechanisms to ensure regulatory compliance.
Supplements the work of independent auditors.

Question 10

Internal auditors should:

Answer 10

Review the reliability and integrity of financial and operating information
Review the systems established to ensure compliance with policies, plans, procedures, laws and regulations
Assess risks within and outside the business
Review the means of minimising risks
Appraise the economy and efficiency of resources
Review operations or programs.

Question 11

Operational auditing:

Five Phases:

Answer 11

• Preliminary preparation – gain a comprehensive understanding of the organisation
• Field survey – identify problem areas and sensitive issues
• Program development – step-by-step program
• Audit application – detailed review
• Reporting and follow-up – with senior management and the audit committee.

Question 12

What are the two major components of the audit expectation gap?

Answer 12

The two major components are the reasonableness gap and the performance gap. The reasonableness gap is the gap between what society expects auditors to achieve and what they can be reasonably expected to accomplish. Whereas the performance gap is the gap between what society can reasonably expect auditors to accomplish and what they are perceived to achieve. The performance gap comprises deficient performance and deficient standards.

Question 13

There were a number of major corporate collapses in the early 2000s. What was the main Australian regulatory response to these problems?

Answer 13

The main regulatory response was through the implementation of the Corporate Law Economic Reform Program (CLERP) 9 in 2004. Some main changes of CLERP 9 were to expand the requirements on independence for auditors and also the creation of the Financial Reporting Council, which had a significant effect on the role of the accounting profession in the regulatory landscape. No longer would the accounting profession in Australia be responsible for the setting of auditing standards.

Question 14

Why is it impossible for an auditor to provide absolute assurance regarding subject matter on which they express their opinion?

Answer 14

It is impossible for the auditor to provide absolute assurance because there are so many judgements in the audit process. The auditor makes a judgement about the risks of material misstatement and then designs procedures accordingly. These procedures use sampling (discussed later in the text) which will always provide some sort of error rate. Even if there was no constraint on cost or time the auditor could not provide absolute assurance because he or she may misinterpret evidence and because there are so many account balances that are the product of significant professional judgement.

Question 15

Types of threats:

Answer 15

Self-interest threats may occur as a result of financial or other interests of a professional accountant, or of an immediate or close family member.

Self-review threats may occur when a previous judgement needs to be re-evaluated by the professional accountant responsible for that judgement.

Advocacy threats may occur when a professional accountant promotes a position of opinion to the point that subsequent objectivity may be compromised.

Familiarity threats may occur when, because of a close relationship, a professional accountant becomes too sympathetic to the interests of others.

Intimidation threats may occur when a professional accountant may be deterred from acting objectively by actual or perceived threats.

Question 16

The cornerstone of the auditing profession:

Describe what is meant by independence in mind and independence in appearance.

Answer 16

The Corporations Act 2001 and Parts 4A & 4B of the Code of Ethics stipulate principles, rules and guidelines in relation to independence.
Section 400.5 – Independence of mind and in appearance
Independence of mind:
State of mind that permits the expression of a conclusion without being affected by influences that compromise professional judgement.
Requires accountant to exercise scepticism and act with integrity and objectivity.
Independence in appearance:
Avoiding situations and facts where a reasonable person would conclude that integrity, objectivity or professional scepticism has been impaired.

Question 17

hat is a Assurance engagement

Answer 17

The Framework for Assurance Engagements (issued by the AUASB) states that an assurance engagement is:
“An engagement in which an assurance practitioner expresses a conclusion designed to enhance the degree of confidence of the intended users other than the responsible party about the outcome of the evaluation or measurement of a subject matter against criteria.”

Question 18

The subject matter of an assurance engagement

Answer 18

Suitable criteria:
Based on relevance, completeness, reliability, neutrality and understandability
Evidence-gathering or engagement process
A conclusion or an assurance report.

Question 19

Assertion-based engagements:

Answer 19

The assurance practitioner provides an opinion on an assertion made about the subject matter.

Question 20

Direct reporting engagements:

Answer 20

The assurance practitioner expresses an opinion on subject matter itself absent of any subject matter information.

Question 21

Benefits of an audit

Answer 21

Access to capital markets — public companies must satisfy statutory audit requirements in accordance with the Corporations Act

A lower cost of capital - potential creditors may offer lower interest rates and potential investors may be willing to accept a lower rate of return on their investment
Audited financial statements improve an entity’s credibility and therefore reduce risks for investors and creditors

Deterrent to inefficiency and fraud – financial report audits can be expected to have a favourable effect on employee efficiency and honesty
Knowledge that an independent audit is to be performed is likely to result in fewer errors in the accounting process and reduce the likelihood of employee misappropriation of assets.

Control and operational improvements – auditor can suggest how controls could be improved and how greater operating efficiencies may be achieved
Weaknesses in controls and suggestions for improvement usually outlined in the management letter.

Question 22

Limitations of an audit

Answer 22

A time lapse – A common criticism of the audit function is that the lapse of time between end of reporting period and the presentation of the audit report may be up to 4 months

Audit testing on selective samples – risk that the sample drawn from the population may not be representative of the sample (sampling risk)

Assessment of materiality – requires a high degree of professional judgement and requires quantitative and qualitative considerations

Highly specialised areas – auditors may be required to form a professional judgement in highly specialised areas or areas that are not dealt adequately by the accounting or auditing standards

Report format limitations:
The audit report and the body of the financial reports are subject to interpretation
The standard format of the audit report may not reflect fully the complexities involved in the audit process and the decision of the audit opinion

Question 23

What is meant by reasonable and limited assurance engagements? Give an example for each type.

Answer 23

Reasonable assurance engagement: aims at reducing risk to an acceptable low level of risk as a basis for a positive conclusion (high but not absolute level of assurance). A limited assurance engagement aims at reducing risks to a level that is acceptable in the circumstances but the risk is greater than for a reasonable assurance engagement, as the basis for a negative conclusion.
The assurance engagement can consist of an outcome, a set of criteria and a subject matter, and include all the assurance engagements where ASAs, ASREs and ASAEs apply. A financial statement audit is a reasonable assurance engagement. A sustainability assurance engagement based on a certain set of criteria is an example of limited assurance engagement.

Question 24

List and explain the elements of an assurance engagement.

Answer 24

An assurance engagement involves three parties: (1) The responsible party – these are responsible for the subject matter, (2) intended user – the person who require assurance on the subject matter, the assurance practitioner, the person who will be providing assurance.
The subject matter is the information that is being reviewed or audited and about which the assurance practitioner will provide an opinion.
Suitable criteria are the criteria around which the subject matter has been prepared and the assurance practitioner will compare the subject matter to the suitable criteria to establish if there are any errors.
Appropriate evidence that the subject matter is free from errors will need to be obtained by the assurance practitioner in order to provide an opinion.
An assurance report is the final element where the assurance practitioner provides a formal opinion to the user.

Question 25

What are the benefits of a financial report audit?

Answer 25

1. Obtain access to capital markets. Without an audit, companies may be denied access to capital markets by the ASX.
2. Have a lower cost of capital. Given the reduced risk resulting from audited financial reports, potential creditors may offer low interest rates and potential investors may be willing to accept a lower rate of return on their investment.
3. Be a deterrent to inefficiency and fraud. Knowledge that an independent audit is to be performed is likely to result in fewer errors in the accounting process and reduce the likelihood of employee misappropriation of assets.
4. Control and operational improvements. Based on observations made during the financial report audit, the independent auditor can suggest how controls could be improved and how greater operating efficiencies within the entity’s organization may be achieved.

Question 26

Qualified opinion

Answer 26

A qualified opinion is given when a company’s financial records have not followed GAAP in all financial transactions.A qualified opinion may be given due to either a limitation in the scope of the audit or an accounting method that did not follow GAAP

A qualified opinion is expressed when the auditor concludes:
that misstatements are material but not pervasive to the financial report, or
when the auditor is unable to obtain sufficient appropriate evidence on which to base the opinion but concludes that the possible effects on the financial report could be material but not pervasive (ASA/ISA 705.07).
The most common types of qualified opinions issued relate to material departures from a specific accounting standard or material disagreements over the carrying value of a specific asset or liability and its potential effect on profit.

Question 27

Unqualified opinion

Answer 27

sometimes referred to as a clean opinion. the auditor reports an unqualified opinion when the financial statements are presumed to be free from material misstatements.

Question 28

adverse opinion

Answer 28

the most unfavourable opinion a business may receive is an adverse opinion, and adverse opinion indicates the financial record contain material and passive misstatement.

Question 29

adverse opinion

Answer 29

the most unfavourable opinion a business may receive is an adverse opinion, and adverse opinion indicates the financial record contain material and passive misstatement.

An adverse opinion should be expressed when the effect of the misstatements, individually or in the aggregate, are so material and pervasive that the financial report taken as a whole is, in the auditor’s opinion, misleading or of little use to the addressee of the auditor’s report (ASA/ISA 705.08).
The most common situation in which they are issued is where the accounts are prepared on a going concern basis and the auditor concludes that it is highly improbable that the entity will continue as a going concern (ASA/ISA 570.21).

Question 30

1. Transaction Level Assertions

Answer 30

Occurrence: Transactions that are recognized in the financial records as having occurred, i.e., did it really happen?

Completeness: Transactions that are completed and supposed to be recorded have been recognized in the financial statements, i.e., did it include all transactions?

Accuracy: Transactions have been accurately reflected within the financial statements at appropriate amounts, i.e., have correct prices, quantities, and calculations been used?

Cut-off: Transactions that have been recognized in correct and relevant accounting time periods.

Classification: Transactions have been classified properly and fairly presented in the financial statements.

Question 31

Account Balance Assertions

Answer 31

Existence: The assets, equity balances, and liabilities exist at the period ending time.

Completeness: The assets, equity balances, and the liabilities that are completed and supposed to be recorded have been recognized in the financial statements.

Rights and Obligations: The entity has ownership rights or the right to benefit from recognized assets on the financial statements. Liabilities recognized in the financial statements represent the actual obligations of the entity.

Valuation: The assets, equity balances, and liabilities have been valued appropriately.

Question 32

Presentation and Disclosure Assertions

Answer 32

Accuracy and Valuation: Transactions, balances, and other financial records have been disclosed accurately and at the appropriate valuations.

Classification and Understandability: Transactions, events, balances, and other financial records have been classified properly and presented in a clear manner that promotes understandability to the users of the financial statements.

Completeness: Transactions, events, balances, and other financial records have been disclosed completely within the financial statements.

Occurrence: Transactions, events, balances, and other financial records have occurred and are related to the entity.

Question 33

Key audit matters

Answer 33

In determining KAMs, the auditor should take into account:
areas at higher risk of material misstatement
significant management judgements
the effect on the audit of significant events or transactions during the period.
2 common KAMs
Goodwill impairment
Revenue recognition.

Question 34

Inherent risk (IR)

Answer 34

is the possibility that a material misstatement could occur in the absence
of related internal controls. This risk exists independently of the audit of a financial report.
The auditor cannot change the actual level of inherent risk

Question 35

Control risk (CR)

Answer 35

) is the risk that a material misstatement could occur and not be prevented 
or detected on a timely basis by the entity’s internal control structure. Control risk is a 
function of the effectiveness of the client’s internal control structure policies and procedures

Question 36

Detection risk (DR)

Answer 36

Detection risk (DR) is the risk that any remaining misstatements will not be detected by 
the auditor’s substantive procedures. Detection risk is a function of the effectiveness of 
audit procedures and their application by the auditor.