Audit II midterm Flashcards
3 approaches to selecting sample items
Select all items
Select specific items- by a characteristic (key item) or all items over a certain dollar amount
Audit sampling
3 factors that determine sample size
Confidence level- desired level of assurance
Tolerable error- acceptable defect rate
Expected error- historical defect rate
Audit sampling
The application of audit procedures to less than 100 percent of the items in a population of audit relevance selected in such a way that the auditor expects the sample to be representative of the population and thus likely to provide a reasonable basis for conclusions about the population
Sampling risk
risk that sample selected is not representative of the population and lead auditor to a different conclusion than if the population were tested
Precision (Allowance for sampling risk) equation
Tolerable error - Expected error
Statistical sampling
Must comply with all laws of probability to compute sample size. Each number must have same probability of being chosen. Any judgement that comes into play makes it non statistical
Pros: Quantify sampling risk, efficient sample
Cons: Training auditors, timely, inconsistency
Non-statistical sampling
Judgement in sample size
Haphazard sample size (auditor selects sample, may be unknown bias)
Must test individually significant items 100%
Cannot quantify upper deviation rate or sampling risk
Monetary Unit Sampling (MUS)
Substantive test, most common method for balances of transactions
Can be quantified
Population: monetary value of an account balance
Each unit is an individual dollar
Misstatement- difference between monetary amounts
Dollars are organized into “logical units”
Confidence level
100% - Sampling risk
The desired level of assurance that the sample results will support a conclusion that the control is functioning effectively.
Generally, when the auditor has decided to rely on controls, the confidence level is set at 90% or 95%.
Tolerable deviation rate
The maximum deviation rate from a prescribed control that the auditor is willing to accept and still consider the control as operating effectively.
Typically 3-5% for high importance, 6-10% for moderate
What determines if accounts are materially misstated, and what to do afterward
If Upper misstatement > Tolerable misstatement, accounts are materially misstated
• Increase the sample size
○ If more misstatements are found then, request client adjust balance
• Perform other substantive procedures
Request client adjust accounts receivable balance
Substantive tests steps
Select a representative sample of items
Calculate the difference between audited values and recorded values for each sampled item
Estimate the population error by multiplying the average error rate in the sample to the population
Adjust for sampling risk (Upper confidence limit)
If the upper confidence limit is less then materiality then the auditor can conclude there is no material misstatement
Disadvantages of MUS
Special consideration for zero or negative balances
Assumes error is not more than 100% of audited amount
Sample results may overstate allowance for sampling risk
Fundamental concepts in Auditing
Integrity Critical thinking Skepticism Verification Independence Validating evidence
agency theory
Assumes principal has different objectives than the agent, and principal does not know agent’s type of actions
Information risk
risk that principal makes decisions improperly based on information provided
Audits became mandatory in _____
1929, after stock market crashed
Major SOX reforms
• Prohibits auditors from Bookkeeping
• Audit committee must hire and fire external auditor
• Audit must pre-approve all non audit services
• Cooling off period: one year period before a member of the audit engagement team can accept an employment at an audit client
• CEO and CFO must certify financial statements
• Established PCAOB- all firms must register and must be inspected either every year or 3 years depending on size of the firm
○ PCAOB has 18 standards: AS1 to AS18
AS 2201 is one of the most important standards
3 required committees on board
Audit committee
Compensation committee
Nomination and governance committee
PCAOB inspections
Inspect quality of individual audit engagements
Inspect the audit firm’s quality control system
Every year for >100 firms, every 3 years for small firms
50 to 70 engagements- Big 4 audit firm
20 to 40 engagements- mid-tier audit firm
1 to 6 engagements- small audit firm
Inspections- areas with frequent deficiencies
Audit sampling procedures (i.e. sampling done improperly) Revenues Inventory and Accounts Receivable Related party transactions Internal control testing Going concern assessments
Audit committee responsibilities
Oversee the financial reporting and disclosure process
Be responsible for the appointment, compensation and removal of the external auditor
Discuss with external auditor the nature and scope of the audit
Discuss problems arising from external and internal audits
Act as a buffer between auditors and management
Review interim and annual financial statements
Sequence of an audit (acceptance to completion)
Client acceptance including engagement letter Risk assessment Audit plan Test and evaluate internal controls Substantive testing Audit completion and reporting
Engagement letter
Contract that lines out auditor’s and management responsibility
Should NOT include audit procedures
Tests of Internal Controls
Inquiry Observation Inspection Designed properly? Applied consistently? Who performs controls?
Substantive tests
Details of transactions and account balances
Transaction assertions
Occurrence Completeness Authorization Accuracy Cutoff Classification
Authorization assertion
All transactions are authorized by appropriate personnel
Accuracy assertion
Transactions are recorded in full amount without errors
Cutoff assertion
Transactions are recorded in the period in which they occurred
Classification assertion
Transactions are recorded in proper account
Balances assertions
Existence
Completeness
Valuation and allocation
Rights and obligations
Rights and obligations
Recorded assets and liabilities are owned/owed by the company
AICPA code of conduct
General guidance: auditor should be honest, objective, competent, exercising due care
Specific rules: Minimum standards of professional behavior
AICPA requires CPA (member) to__
Identify threats
Evaluate significance of threats
Apply safeguards
7 types of threats
Adverse Interest- c
Advocacy- member endorses a client’s service or product
Familiarity
Management Participation- a member will take management role during engagement
Self-interest
Self-review
Undue influence
Sources of safeguards
Profession, legislation or regulation of auditors
Clients (tone at the top)
The audit firm policies
Auditor independence overarching question
Would a circumstance lead a reasonable person who is aware of all the relevant facts to conclude that there is an unacceptable threat to the member’s and the firm’s independence.
3 elements to professional skepticism
Attributes- knowledge, skill, ability
Attitude- mindset, faith, integrity
Actions- evaluate evidence
All three must be met
Barriers to professional skepticism
Incentives and pressure to maintain clients
Desire to avoid conflict, due to personal or professional characteristics
Need to maintain a low audit fee, or desire to provide other services to a client
Too much trust in the client
Scheduling or workload demands
Ratio projection
Assume the auditor finds $1,500 in misstatements in a sample of $15,000. The misstatement ratio is 10%. If the population total is $200,000, the projected misstatement would be $20,000 ($200,000 × 10%)
Difference projection
Projects the average misstatement per item.
Assume misstatements in a sample of 100 items total $300 (for an average misstatement of $3), and the population contains 10,000 items. The projected misstatement would be $30,000 ($3 × 10,000).
Audit risk definition and formula
The risk that the audit opinion is unqualified when the financial statements are materially misstated.
Auditor sets the acceptable level.
Inherent risk x Control risk x Detection risk
Detection risk
Risk that auditor will not detect misstatements.
Auditor can control
Business risk
an auditor’s risk of financial loss and damage to professional reputation
Risk of material misstatement formula
Inherent risk x control risk
What determines Risk of material misstatement
Revenue has a higher RMM Industry, regulatory factors Nature of entity Internal controls Objectivity
Client business risk
Any factors, pressures, and forces that bear on entity’s ability to survive and profit
Management preoccupation with earnings targets affects ________
Inherent risk
Securities offerings and acquisitions financed with equity including insider sales affects____
Inherent risk
Management compensation contracts incentives affects _____
Inherent risk
Going concern risks and financial distress affects _______
Inherent risk
Debt covenants and regulatory capital requirements affects _______
Inherent risk
Change in senior management, operating activities or economic environment affects ________
Inherent risk
Related party transactions affects ______
Inherent risk
Operating cycle assets and liabilities affects _____
Inherent risk
Attitudes of management and the AC towards internal control and corporate governance affects _____
Control risk
Honesty and competence of employees affects ______
Control risk
Formal structure and authorization procedures affects _______
Control risk
Adequate staffing of accounting and recordkeeping functions and employee turnover affects ______
Control risk
Volume of transactions affects ______
Control risk
Adequate segregation of duties affects _____
Control risk
3 important segregation of duties
Operational (sales) and Accounting
Custody of Assets and Accounting
Custody of Assets and Authorization
Gathering evidence for risk assessment
Inquiries of management- see how well management knows it works, and get an understanding of how well it works
Analytical procedures- Assess risk of material misstatement due to error or fraud
Observation and inspection
Response to risk assessment
Emphasize professional skepticism
Properly assign responsibility to engagement team
Sufficient supervision
Insert an element of unpredictability in conduct of the audit
Deviation
Departure from adequate performance of internal control
Materiality
The magnitude of an omission or misstatement of accounting information that makes it probable that the judgment of a reasonable person relying on the information would be changed or influenced by the omission or misstatement.
Requires professional judgement
Applying materiality steps
Determine materiality for overall financial statements (planning materiality)
Determine tolerable misstatement (allocate materiality at individual account/class of transaction level)
Evaluate audit findings against materiality for planning (end of the audit)
Quantitative materiality thresholds
3-5% of Income before tax, Income from continuing operations
0.5% of total revenues, total assets
Qualitative factors that affect quantitative materiality
Company is close to violating loan covenants At or near break-even in earnings High management turnover Market pressures Risk of Bankruptcy
Audit evidence
All the information, whether obtained from audit procedures or other sources, that is used by the auditor in arriving at the conclusions on which the auditor’s opinion is based
3 concepts to audit evidence
Nature (what is collected, accounting records, confirmations, etc.)
Sufficiency and appropriateness of audit evidence
Evaluation of audit evidence- unbiased, considers all evidence equally
Sufficiency of audit evidence
The quantity of evidence compared to what is needed, depends on risk of material misstatement
Steps of performing an audit
Observation Inquiry Inspection Confirmation Recalculation Reperformance Analytical Procedures
Audit Confirmation
Obtaining a representation of information of an existing condition directly from a third party
Usually very reliable
Required for A/R
Analytical procedures
Evaluation of financial information through plausible relationships
Required in planning and completion
Evaluative procedures
Auditor compares results with prior periods, expected results, similar companies
Predictive procedures
Audit compares results to an expected amount he developed
