Audit Lecture 6

Question 1

What are the six principles of the AICPA Code of Professional Conduct?

Answer 1

The six principles of the Code of Conduct are:

• Responsibilities
• Public Interest
• Integrity
• Objectivity and independence
• Due care
• Scope and nature of services

Question 2

Under the AICPA Code of Professional Conduct, independence is impaired:

Answer 2

1. If a member has a direct financial interest with attestation clients without regard to materiality;
2. If a member has a material indirect financial interest in the client;
3. If a member or a member’s immediate family member has a loan to or from the client;
4. If a member accepts more than a token gift;
5. If a member is an employee of or makes management decisions on behalf of the client;
6. If the client is overdue more than one year in the payment of professional fees to the member; or
7. If ther is actual or threatened litigation between the member and the client.

Question 3

Under the AICPA Code of Professional Conduct, when is independence impaired by employment relationships?

Answer 3

Independence is impaired when:

• An individual who was formerly employed by the client participates on the engagement team or is in a position to influence the engagement when the engagement covers a period of his or her former employment with the client.
• An immediate family member or close relative is employed in a key position by the client.
• A partner or professional employee leaves the firm and is employed by the client in a key position, unless the individual is no longer in a position of influence or participate in a firm’s decisions and the amounts due to the individual are immaterial to the firm.

Question 4

Generally, independence rules apply to a covered member and their spouse and dependents. According to SEC rules, what independence rules apply to close relatives?

Answer 4

According to SEC rules, independence is impaired if the close family member:

• has an accounting role or financial reporting oversight role with the SEC audit client (e.g., the family member is a treasurer, CFO, accounting supervisor, or controller); or
• owns more than 5 percent of a client’s equity securities or controls the client.

Note: Independence is also considered to be impaired if any partner’s close family member controls an SEC audit client.

Question 5

According to the AICPA Code of Professional Conduct, what independence rules apply to close relatives?

Answer 5

According to the AICPA Code of Professional Conduct, the member’s independence is impaired when the close family member is:

• Employed by a client in a key position (except for covered members who provide only non-attest services to a client.)
• Aware that the close relative has a financial interest in the client that either:
  
  • was material to the relative’s net worth; or
  • enables the relative to exercise significant influence over the client.

Question 6

Based on the AICPA Code of Professional Conduct, provide some examples of acts considered discreditable to the profession.

Answer 6

Examples of acts considered discreditable to the profession include:

• Failure to return records to the client after the client makes demand.
• Determination by a court or administrative agency of discrimination or harassment in public practice.
• Negligence in preparing fincial statements or records.
• Failing to follow GAAS or other applicable standards of government agencies unless the member discloses that the stardards were not followed and the reasons for noncompliance.
• Solicitation or disclosure of CPA Examination question and answers.
• Failure to timely file a personal or firm tax return or to timely remit payroll or other taxes collected on behalf of others.
• Marketing a member’s abilities to provide professional services or making claims about the member’s experience or qualifications in a manner that is false, misleading or deceptive.
• Member whose employment relationship is terminated and takes or retains (a) originals or copies (in any format) from the firm’s client files; or (b) proprietary information without the firm’s permission, unless the member has a contractual arrangement with the firm allowing such action.
• Disclosing confidental information obtained from a prospective client or non-client without consent.

Question 7

According to the AICPA Code of Professional Conduct, a departure from GAAP may be justified under what circumstances?

Answer 7

A departure from GAAP may be justified only if compliance with GAAP would cause the financial statements to be misleading.

Question 8

According to the AICPA Code of Professional Conduct, in what circumstances must a CPA disclose confidential client information without the consent of a client?

Answer 8

A CPA must disclose confidential information without the client consent under the following circumstances:

• It is necessary to comply with a valid subpeona or summons.
• As part of a quality review of the CPA’s professional practives authorized by the AICPA.
• In response to any inquiry made by the ethics division of the trial board of the AICPA, or by a duly-constituted investigative body of a state CPA society.

Question 9

According to the AICPA Code of Professional Conduct, when are contingent fees prohibited?

Answer 9

Contingent fees are prohibited for:

• Audits of financial statements
• Reviews of financial statements
• Examinations of prospective financial information
• Preparing an original or amended tax return or claim for a tax refund

Question 10

According to the AICPA Code of Professional Conduct, when are contingent fees permitted?

Answer 10

Contingent fees are permitted:

1. For compilations of financial statements expected to be used by third parties only if the member includes a statement that the member is not independent.
2. Fees are not regarded to be contingent when they are fixed by courts or other public authorities or in tax matters, if they are based on the results of court proceedings or the findings of governmental agencies (e.g., a contingent fee is permitted when representing a client in an examination of a tax return by an IRS agent).

Question 11

Explain the conceptual framework approach utilized by the AICPA Code of Professional Conduct.

Answer 11

The conceptual framework approach requires entities to:

1. Identify threats to compliance with fundamental principles.
2. Evaluate the significance of the threat.
3. Apply safeguards to eliminate threats or reduce threats to an acceptable level, whenever possible.

Note: IFAC’s Code of Ethics and GAGAS Conceptual Framework for Independence utilize a similar approach.

Question 12

Identify threats to compliance with fundamental principles included within the AICPA Code of Professional Conduct.

Answer 12

Threats to compliance include:

• Adverse interest threat
• Advocacy threat
• Familiarity threat
• Management participation threat
• Self-interest threat
• Self-review threat
• Undue influence threat

Question 13

Define and provide an example of adverse interest threat.

Answer 13

The threat that a member will not act with objectivity because the member’s interests are opposed to the client’s or employing organization interests.

For example, a member experiences an adverse interest threat if he or she is commencing litigation against their client/employing organization.

Question 14

Define and provide an example of advocacy threat.

Answer 14

The threat that a member will promote the client’s or employing organization’s interest to the point that his or her objectivity or independence, as applicable, is compromised.

For example, a member experiences advocacy threat when he or she endorses a client’s services or products.

Question 15

Define and provide an example of familiarity threat.

Answer 15

The threat that, due to a long or close relationship with the client or employing organization, a member will become too accepting of the product or service and/or too sympathetic to the client or employing organization’s interests.

For example, a member experiences familiarity threat when a close friend is employed by the client.

Question 16

Define and provide an example of management participation threat.

Answer 16

The threat that a member will take on the role of client management or otherwise assume management responsibilities.

For example, a member experiences management participation threat if he or she serves as an officer or a director of an attest client.

This threat exists for members engaged in attest engagements. This threat does not apply to members in business.

Question 17

Define and provide an example of self-interest threat.

Answer 17

The threat that a member could benefit financially or otherwise from an interest in, or relationship with, a client or employing organization or persons associated with the client or employing organization.

For example, a self-interest threat occurs when a member is eligible for a profit or other performance-related bonus at the employing organization and the value of that bonus is directly affected by the member’s decisions.

Question 18

Define and provide an example of self-review threat.

Answer 18

The threat that a member will not appropriately evaluate:

• the results of a previous judgement made; or
• a service performed or supervised by the member; or
• an individual in the member’s firm or employing organization; and
• that the member will rely on that service in forming a judgment ad part of another service.

For example, a member in a public practice would experience self-review threat when performing bookkeeping services for a client.

Question 19

Define and provide an example of undue influence threat.

Answer 19

The threat that a member will subordinate his or her judgement to an individual associated with a client or employing organization or any relevant third party due to that individual’s reputation or expertise, aggressive or dominant personality, or attempts to coerce or exercise excessive influence over the member.

For example, a member would experience undue influence threat if he or she is pressured to become associated with misleading information.

Question 20

What is an “issuer,” and what group establishes standards for audit reports of issuers?

Answer 20

An issuer is an entity subject to the rules of the SEC (this would include primarily public companies).

The Public Company Accounting Oversight Board (PCAOB) establishes standards for audit reports for issuers.

Question 21

Title I of the Sarbanes-Oxley Act of 2002 (SOX) requires that registered firms must adhere to what auditing standards?

Answer 21

• Audit workpapers must be maintained for seven years.
• A concurring or second partner review is required for each audit report.
• The audit report must describe the scope of the testing of the issuer’s internal controls.

Question 22

Under SOX Title II and SEC Regulation S-X, what services must be preapproved by the audit committee?

Answer 22

All auditing services and permitted non-audit services (including tax services) must be preapproved by the audit committee. Note: Audit committees may apply a de minimis exception to the preapproval requirements of non-audit services provided that those services:

1. do not aggregate to more than five percent of the total revenues from the audit client during the fiscal year when services are provided;
2. were not recognized as non-audit services at the time of the engagement; and
3. are promptly brought to the attention of the audit committee and approved prior to the completion of the audit.

Question 23

Under SOX Title II, what services may not be provided to an audit client?

Answer 23

Prohibited services include:

• Bookkeeping
• Financial information systems design and implementation
• Appraisal and valuation services
• Management funcations and HR functions
• Internal audit outsourcing services
• Investment-related services
• Legal services
• Expert services unrelated to the audit

(Note: SEC Regulation S-X contains these same rules.)

Question 24

What are the audit partner rotation rules under SOX Title II and SEC Regulation S-X?

Answer 24

• Both SOX and Regulation S-X require the lead and concurring partner to rotate off the audit overy five years. Lead and concurring partners are subject to a fiv-year “time out” period.
• Regulation S-X further requires other partners to rotate off every seven years. Other partners are subject to a two-year “time out” period.

Question 25

What must be reported by the auditor to the audit committee under SOX Title II and SEC Regulation S-X?

Answer 25

• Critical accounting policies and procedures used.
• Alternative accounting treatments discussed with management, the ramifications of alternatives, and the treatment preferred by the auditor.
• Material written communications between the auditor and management.

Question 26

What is the required cooling-off period under SOX Title II and SEC Regulation S-X?

Answer 26

The audit firm cannot have employed an issuer’s CEO, CFO, controller, CAO, or other employee in a financial reporting oversight role during the one year preceding the audit.

Question 27

What is the required content of management’s internal control report under SOX Title IV?

Answer 27

• Management’s responsibility for establishing an adequate internal control structure for financial reporting.
• An assessment of the effectiveness of the current year’s control structure.

Question 28

The SEC requires issuers to disclose whether or not (and if not, why not) the audit committee has at least one member who is a financial expert. What qualifies as a financial expert?

Answer 28

A financial expert qualifies through:

1. education and experience as a principal financial officer, principal accounting officer, public accountant or auditor, or experience in one or more position that involve the performance of similar functions.
2. experience actively supervising a principal financial officer, principal accounting officer, controller, public accountant, auditor or person performing similar functions, or experience overseeing or assessing the performance of companies or public accountants with respect to the preparation, auditing, or evaluation of financial statements; or
3. other relevant experience.

Question 29

What knowledge should a financial expert on the audit committee have?

Answer 29

Knowledge of a financial expert should include:

1. an understanding of financial statements and generally accepted accounting principles;
2. an ability to assess the general application of such principles in connection with the accounting of estimates, accruals, and reserves;
3. experience preparing, auditing, analyzing, or evaluating financial statements that present a breadth and level of complexity of accounting issuers that are generally comparable to the breadth and complexity of issues that can reasonably be expected to be raised by the registrant’s financial statements, or experience actively supervising one or more persons engaged in such activities;
4. an understanding of internal controls and procedures for financial reporting; and
5. an understanding of audit committee functions.

Question 30

What are the PCOAB’s tax-related independence rules?

Answer 30

• Registered firms may not provide confidential or aggressive tax transactions to audit clients.
• Registered firms may not provide tax services to corporate officers or audit clients or their immediate family members.
• Audit committee must preapprove tax services and related fees.

Question 31

Under the SEC’s principles of independence, a client relationship or a service provided to an audit client would create independence issues if it:

Answer 31

• Creates a mutual or conflicting interest between the auditor and client.
• Results in the auditor acting as management or an employee of the audit client.
• Places the auditor in a position of auditing his or her own work.
• Makes the auditor an advocate for the audit client.

Question 32

Explain the conceptual framework approach under IFAC’s Code of Ethics and identify threats to compliance with its fundamental principles.

Answer 32

IFAC’s Code is based on a conceptual framework (versus a set of rules) that requires entities to identify, evaluate, and address threats to compliance with its fundamental principles. These threats include:

• Self-interest threat
• Self-review threat
• Advocacy threat
• Familiarity threat
• Intimidation threat

Question 33

How long must audit documentation be retained for issuers and nonissuers?

Answer 33

PCAOB rules require that auditors retain audit documentation of public companies (issuers) for seven years from the report release date.

SAS rules require that auditors keep audit documentation for nonissuers for at least five years from the report release date.

The report release date is the date on which the auditor gives the client permission to use the report (often the date the report is delivered to the client).

Question 34

Define permanent (continuous) file and provide examples of audit documentation that may be included within.

Answer 34

The permanent file includes audit documentation that has a continuing interest from year to year. Examples of audit documentation that may appear in the permanent file include:

• Contracts
• Pension plans
• Leases
• Stock options
• Bylaws
• Articles of incorporation
• Bond indentures

Question 35

What are the advantages and disadvantages of auditing with a computer?

Answer 35

Advantages:

• Fewer math errors due to automatic performance of math on all documents.
• Automatic cross-referencing of amounts by linking each lead schedule to the working trial balance and financial statements.
• Automatic preparation of financial statements, tax return schedules, and consolidating schedules.
• Reduction in required supervisory review time.
• Automatic performance of certain analytical review procedures.
• Enhanced client service.
• Improved morale and productivity for audit team.

Disadvantages:

• Audit documentation may not contain readily observable details of calculations.

Question 36

Describe “auditing around the computer” and identify when it is appropriate and not appropriate.

Answer 36

When auditing around the computer, the auditor does not directly test the application program, but instead tests the input data, processes the data independently, and then compares the independent results to the program results.

This method is appropriate for simple batch systems that have a good audit trail. Auditing around the computer is not appropriate when there is insufficient paper-based evidence.

Question 37

List and briefly define the types of computer assisted audits techniques (CAATs) that may be used.

Answer 37

• Transaction tagging–electronically marks specific transactions.
• Embedded audit modules–sections of program code collect data for the auditor.
• Test data–use of the client’s system to process the auditor’s data, off-line.
• Integrated test facility–use of the client’s system to process the auditor’s data, online.
• Parallel simulation–use of the auditor’s system to re-process client data.

Question 38

In conducting an audit of an organization receiving federal financial assistance, what additional audit procedures must be performed in addition to the general requirements of GAAS and GAGAS?

Answer 38

Those procedures performed under GAAS and GAGAS plus:

• The auditor should obtain and document an understanding of internal control established to ensure compliance with the laws and regulations applicable to the federal financial assisstance.
• In some instances, tests of controls are mandated to evaluate the effectiveness of such controls.

Question 39

Audits of governmental entities may draw on up to three sets of standards or supplementary requirements. What are they and what are the circumstances that surround their application?

Answer 39

Generally Accepted Auditing Standards (all audits)

Generally Accepted Government Auditing Standards (Yellow Book audits): auditee is a government, or receives financial assisstance from the government

2 CFR 200.500 (Single Audits of Federal Financial Assistance): an entity expending more than $750,000 in federal financial assisstance annually

Question 40

Identify the additional auditor responsibilities associated with government audits under GAGAS.

Answer 40

• Obtaining an understanding of how laws, rules, and regulations relate to financial statements amounts.
• Assessing the degree to which management has identified laws, rules, and regulations that have a material impace on financial statement amounts.
• Obtaining reasonable assurance that financial statements are free from material misstatements resulting from violations of laws, rules, and regulations associated with the determination of financial statement amounts.
• Communication to management, as appropriate, that GAAS procedures alone will not fulfill additional audit requirements related to an audit of a government or of governmental assistance.

Question 41

Identify the three types of governmental audits/engagements normally undertaken by CPAs.

Answer 41

Financial Audits
Engagements primarily designed to determine the fair presentation of financial statements in conformity with GAAP or an OCBOA. Financial audits also include audits of specified elements of the financial statements, etc.

Attestation Engagements
Examinations, reviews, and agreed upon procedures, etc.

Performance Audits
Effectiveness, economy, and efficiency audits, internal control and compliance audits.

Question 42

In conducting an audit of an organization under Generally Accepted Government Auditing Standards, what audit documentation, in addition to that required by Generally Accepted Auditing Standards, must be included?

Answer 42

Internal control documentation must include:

• Consideration of procedures that ensure the auditee’s compliance with laws, rules, and regulations.
• Written representations from management with regard to management’s identification of material laws, rules, and regulations; management’s responsibility got ensuring compliance with laws, rules, and regulations; and management’s knowledge of any violations that should be disclosed or recorded.

Question 43

When reporting on a client’s internal control deficiencies and weaknesses under GAGAS, the auditor is required to perform which procedures?

Answer 43

When reporting on a client’s internal controls, the auditor must:

• obtain an understanding of the design of relevant controls and determine whether they have been implemented;
• communicate all significant deficiencies noted during the audit, even those that do not result in material weaknesses;
• prepare a written report on the auditor’s understanding of the client’s internal control and assessment of control risk; and
• report significant deficiencies to specific legislative and regulatory bodies.

Note: The third and fourth bullet points are required under GAGAS, not GAAS.

Question 44

How does materiality under the Single Audit Act differ from materiality under both GAAS and GAGAS?

Answer 44

Under the Single Audit Act, materiality is considered in relation to each major program, not simply the financial statements.

Question 45

What are the two types of requirements surrounding federal financial assistance programs?

Answer 45

• General requirements involve national policy and apply to most federal assisstance programs.
• Specific requirements apply to a particular federal program and generally arise from statutory requirements.

Question 46

Material instances of noncompliance include:

Answer 46

• Failure to follow requirements.
• Violations of rules contained in statutes, regulations, contracts or grants.

Question 47

Discovery of illegal acts requires specific written communication under different circumstances.

Which parties may be notified?

Answer 47

Any of the following may be notified of illegal acts:

• Top officials of entity
• Appropriate oversight/governance bodies
• Officials of the entity’s audit organization

Question 48

Under what circumstances must discovered instances of fraud or other illegal acts be communicated directly to the applicable federal Inspector General?

Answer 48

• Management fails to disclose the discovered illegal action to the grantor.
• Management does not take appropriate remedial action.

Question 49

What are the four reports recommended under the Single Audit Act?

Answer 49

Under the Single Audit Act, the following reports are recommended:

• Opinion on financial statements and supplementary schedule of expenditures of federal awards.
• Report on compliance and on internal control over financial reporting based on a financial statement audit.
• Report on compliance and on internal control over compliance applicable to each major program.
• Schedule of findings and questioned costs.

Question 50

Which laws and regulations need to be considered by the auditor in a government audit?

Answer 50

The auditor must consider the effects of laws and regulations that have a direct and material effect on the determination of amounts in the entity’s financial statements.

Question 51

What are the specific requirements for an auditing firm relative to quality reviews of their government audits?

Answer 51

External quality reviews must be conducted every three years and a copy of the review report must be provided to the auditee.

Question 52

Identify the additional management responsibilities associated with government audits.

Answer 52

• Identification of applicable laws and regulations with compliance requirements.
• Establishment of internal controls to provide reasonable assurance that the entity complies with those laws and regulations.
• Preparation of supplementary financial reports, including a “Schedule of Expenditures of Federal Awards.”
• Obtaining an audit that satisfies relevant legal, regulatory, or contractual requirements.

Question 53

What are the objectives of a single audit?

Answer 53

• Audit of the entity’s financial statements and reporting on a separate schedule of expenditures of federal awards.
• Compliance audit of federal awards expended during the year, as a basis for issuing additional reports on compliance and on internal control over compliance for major programs.

Question 54

Control evaluations made for purposes of performing an audit in accordance with the Single Audit Act are made in relation to individual compliance areas applicable to each major program. Such evaluations are limited to compliance requirements that could have a direct and material impact on major programs and include what requirements?

Answer 54

1. Tests of controls must be performed to evaluate the effectiveness of the internal control (unless the control is deemed to be ineffective).
2. Controls deemed to be ineffective result in expanded procedures, including:
   
   1. Assessment of control risk at the maximum.
   2. Consideration of the impact on weak controls on substantive compliance testing.
   3. Reporting a signficant deficiency (reportable condition) or material weakness as an audit finding.

Question 55

Material noncompliance with the requirements of major federal financial assistance programs results in what type of opinion on compliance?

Answer 55

Qualified (except for) or adverse opinions on compliance will be rendered in the event of discovery of material reportable instances of noncompliance.

Question 56

List the ethical principles under GAGAS.

Answer 56

1. Serving the public interest
2. Integrity
3. Objectivity
4. Proper use of governmental information, resources, and positions
5. Professional behavior

Question 57

List the two general characteristics of independence under GAGAS.

Answer 57

1. Independence of mind
2. Independence in appearance

Question 58

What are the four steps in evaluation of auditor independence under GAGAS?

Answer 58

1. Identification of threats to independence.
2. Evaluation of the signficance of threats identified both individually and in the aggregate.
3. Application of safeguards necessary to eliminate threats to reduce them to an acceptable level.
4. Conclude if safeguards are adequate to eliminate or appropriately reduce threats.

Question 59

List the seven different threats to auditor independence under GAGAS.

Answer 59

1. Self-interest threat
2. Self-review threat
3. Bias threat
4. Familiarity threat
5. Undue influence threat
6. Management participation threat
7. Structural threat

Question 60

Under Generally Accepted Government Auditing Standards, the critical feature in determining whether a non-audit service is a threat to independence is:

Answer 60

Consideration of management’s ability to effectively oversee the non-audit service to be performed. The auditor should determine:

1. that the audited entity has designated an individual who possesses suitable skill, knowledge and experience; and
2. that the individual understands the services to be performed sufficiently to oversee them.

Question 61

Determine the number of opinions required for a financial statement audit that falls under government auditing standards.

Answer 61

One opinion is required for a financial statement audit that falls under government auditing standards, which is on the fairness of the financial statements.

Note: Government auditing standards also require a report on internal control and compliance with provisions of laws, regulations, contracts, and grant agreements. This report is not required to include an opinion.

Question 62

Name the elements of a CPA firm’s system of quality control for auditing, attest, and accounting and review services.

[HELP ME]

Answer 62

Human resources

Engagement/client acceptance and continuance

Leadership responsibilities

Performance of the engagement

Monitoring

Ethical requirements

Question 63

What are the objectives of an auditor when implementing quality control procedures at the engagement level?

Answer 63

The objectives of the auditor are to provide reasonable assurance:

• That the audit complies with professional standards and any legal or regulatory requirements.
• That the report issued by the auditor is appropriate for the engagement.

Question 64

Explain the relationship between quality control standards and GAAS standards.

Answer 64

Quality control standards pertain to conduct of all professional activities of an entity’s practice as a whole.

GAAS standards relate to the conduct of each individual audit engagement.