Auditing Flashcards
The accounting system diagram? (1.2)
- Transaction goes into accounting information system. From accounting information system, info goes to stakeholders of the firm and managements, however, auditor also checks accounting information system and the info which goes from accounting information system to the stakeholders
Layman definition of auditing (1.16/17)
- Auditing is a process in which a business requests an audit firm to examine its accounting records and certify whether the numbers reported in financial statements are accurate
Parties involved in organization (1.22) 4 parties
- Management
Prepares and presents F$
Designs, implements & maintains internal control over financial reporting o Provides info to auditors - Internal audit function
Gives assurance on internal control (IC) to managers and audit committee - External auditor
Provides independent audit of internal control and financial statement (FS) - Audit committee
Subcommittee of board of directors (BoD)
Oversees managers and internal audit
Hire external auditor
Formal definition of audit / A statement of basic audit concepts (1971). (1.23)
- An audit is a systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of corresponderice between these assertions and established criteria, and communicating the results to interested users
With what 2 things does credible information help with? (1.25)
- Reduces risk (risk-return trade off)
- Improves decision making process
What does “Pittman and Fortin (2004) say about: Which companies young/old with a high quality auditor pay significantly lower interest rates (1.25)
young companies
How can an auditor solve info problems? Regarding lending bank and debtholders (Jensen and Meckling (1976) (1.25)
- By providing valuable information about a borrowing firm to a lending bank, potentially lowering the monitoring costs of debtholders
5 points of insurance role of auditing? (1.26) weirdly asked question, he would ask differently.
- Auditors provide reasonable assurance about the accuracy of the financial statements of a company
- Users rely on these audited financial statements to make their decisions
- Users can sue auditors to recover their losses.
- Identification of material misstatement in financial statements
- Proven that auditors have worked negligently (In a way that is not careful enough)
2 points of signaling role of auditing? (1.27)
- Audit is indication of transparency
- Enhances the perception of a company (low risk company
When is the audit mandatory in the US? (1.30)
- Only required for public companies and certain other regulated entities. PCAOB oversees audits of public companies.
What does PCAOB mean? (Google filled the knowledge gap)
- Pubic Company Accounting Oversight Board. Created by the Sarbanes-Oxley Act of 2002. A nonprofit corporation established by Congress to oversee accounting professionals who provide independent audit reports for publicly traded companies.
- Registering public accounting firms. Establishing audit, quality control, ethics, independence, other standards relating to audits of public company audits. Enforcing compliance with the Sarbanes-Oxey Act
What was the Sarbanes-Oxley Act about? (Knowledge gap). It’s two points?
-Is a federal law that established broad auditing and financial regulations (record keeping and reporting) for public companies.
When is the audit necessary in the Netherlands? (1.30]
- If the company meets 2 of the 3 criteria in 2 successive years
o Total assets > 6mln euros
o Net sales > 12mln euros
o Average number of employees > 50
What does AFM stand for? And what does it do? (1.30)
- The Dutch Authority for the Financial Markets.
- Responsible for supervising the operations of the financial markets since 1 March 2002 (Savings, investment, insurance, loans, pensions, capital markets, asset management, accountancy and financial reporting)
The history of audit? (Video in the slides)
- The first references of audit came around 2000BC in Roman Empire. The emperor’s appointed bright and ambitious men that they considered trustworthy as Cuesta’s. They were sent to the far lands of Roman empire to ensure that the governors who rules the provinces was spending the money (that Rome has sent) correctly. The assets that money had bought were protected and looked after and existed. And taxes which governors had to collect and sent to Rome were being collected and sent to Rome, without governors taking a persentage off to themselves.
o In short: governor appoins a person who he trusts to verify financial expenditure, assets and that no fraud is being commited. - 1068-1100 AD Henry the first of England, was first that used the word audit. From latin ‘audre’ meaning: to hear. He sent auditors to the corners of England to confirmt that the barons who ruled on his behalf were spending the money as it should be sent, assets were protected, taxes collected and sent to the king.
- The key to the audit, which we see today, was invented due to Industrial Revolution in 1760-1840. For the first time, investors became part of the business process. But investors would only invest their money in something they believe is safe, and understandable, so they appointed people they considered trustworthy (often business associates and friends) to verify that the provided information by the management, the people behind the potential business was true and fair.
- After the stock market crash in 1929 regulations became harsher. Now auditors needed to be qualified professionals, not your friends. Technologies involved, so people turned to that, and we had to adapt techniques to that as well.
- Auditing scandals in 1980s – 1990s brought futher improvements in regulations. Enron scandal. Enron were audited by Arthur Andersen (the largest and most successful audit firm of that time). Because of the scandal, they lost reputation and they had to close.
How does the graph look like when there is a divergence of interest effect? In terms of management ownership and agency cost (1.38)
- Straight line from high agency cost to low agancy cost by the increase in management ownership.
What does entrenchement effect mean? How does the graph look like? (1.39)
- Managers have more scope for behaving opportunistically when they have greater control.
How does the graph look like when we combine entrenchment effect and divergence of interest? (1.40)
Answer it. graph is in the slides if needed.
What could be 4 solutions to the agency problem? (1.41)
- Board of directors
o Have skills
o Willing to spend time
o Monitor performance through financial statements - Managerial compensation
o Link managerial compensation with shareholder wealth
o Managerial performance is measured through financial statements - Managerial ownership
- Audit
A firm is more likely to purchase voluntary audits if…? Dedman, Kausar, Lennox (2014) (1.45)
- Agency cost higher (size, complex, ownership dispersion)
- Riskier (performance, age, inventory or receivable)
- Raise capital
- Purchase non-audit services from auditor (knowledge spillover?)
- Exhibit greater demand for audit under mandatory regime (fee, B4?)
A high-quality audit is when….? (2.6)
- An audit performed in accordanve with GAAS (Generally Accepted Auditing Standards) to provide reasonable assurance that the audited financial statement and related disclosures are
1. Presented in accordance with GAAP and
2. Are not materially misstated whether due to error or fraud.
According to DeAngelo (1981) audit quality equals to what? (2.7)
- Audit quality = competence + independence
- Joint probability that a given auditor will both detect material misstatements in the client’s financial statements (technical capabilities = competence) and report the material misstatements (auditor independence)
Drivers of audit quality? 5 of them. (2.10)
- Effectiveness of the audit process +
- Reliability and usefulness of audit reporting +
- Factors outside the control of auditors +
- Audit firm culture +
- Skills and qualities of the audit partner and the engagement team +
Structure of AEG (Audit expectation gap) (was asked in the exam and I struggled to explain) (2.11) (Porter 1993)
The audit expectation gap is a term used to describe the difference between what the general public expects from the audit, and what a financial audit actually involves.
- There are 2 parts: performance gap and reasonableness gap.
- Reasonableness gap (what the public expects auditors to achieve and what they can reasonably be expected to accomplish).
- In performance gap there are deficient performance (the expected standard of performance of auditors 16%) and deficient standards (expectations defined by the law and profession standards 50%).
What is not ethics? (2.14)
- Being ethical is not a matter of following one’s feelings. In fact, feelings frequently deviate from what is ‘ethical’
- Ethics cannot be confined to religion nor is the same as religion
- Ethics are not necessarily determined by law
- Being ethical is not the same as doing “whatever society accepts”
What is ethics? (2.14)!
- Ethics = standards of behavior (set of moral principles and values) that suggest how human beings should act
A few ethical dilemmas to auditors: (2.16)
- Dealing with a client who threatens to seek a new auditor unless an unqualified opinion is issued.
- Deciding whether to confront a supervisor who has materially overstated departmental revenues as a means of receiving a larger bonus
- Continuing to be part of management of a company that harasses and mistreats employess or treats customers dishonestly (if you have a family to support and the job market is tight)
- Cheating for your final CPA exam (to safeguard your future career prospects)
- Dealing with budget pressure (decision to shift audit hours from a client with tight budget to the one with a loser one)
Professional conduct (behavior)? (2.17)
- GAAS
- CPA examination
- Code of prefessional conduct
- Peer review
- Continuing education req.
- Legal liabilities
- Quality control.
- AFM, PCAOB, SEC
What are the ethical principles of code of professional conduct (behavior)? (2.18)
I name it: IOS RC
1. Integrity = fairness, truthfulness
2. Objectivity = be free of conflicts of interest
3. Secrecy
4. Responsibilites = commitment to professionalism
5. Competence and due care = competence is up-to-date
What are the threats of code of professional conduct (behavior)? (2.19)
I name it: SASI FIA
- self-interest = financial or other interest of an auditor
- Self-assesment = threat coming from the idea that auditor itself assesses his or her own performance
- Advocacy = not being objective
- Intimidation = factual or alleged threats
- Familiarity = close connections between the auditor and the client
What is the difference between independence in fact vs appearance? (2.20)
- In fact = whether the auditor is actually able to maintain an unbiased attitude throughout the audit. He is objective, no conflict of interest
- In appearance = is the result of others’ interpretation of this ‘independence’
o A third-party view - Important: if auditors are independent in fact, yet users believe them to be advocates (supporter) for the client, most of the value of the audit function is lost
Lennox (one of the auditors) showed “employment affiliation”. What does it mean?
- An employment affiliation occurs when an individual leaves and audit firm and joins one of the audit firm’s clients.
Alma mater affiliation? (2.22)
- An alma mater affiliation occurs when an executive persuades her company to appoint her former CPA (accounting firm) firm as the company’s auditor. An affiliated executive may have a preference for her former audit firm.
- Lennox argues that audit quality can be impaired when executives previously worked for their companies’ audit firms.
o Audit team members might be overly friendly with their former colleague and are unwilling to challenge her assertions
o The former auditor might be sufficiently familiar with the audit firm’s testing methodology that she can circumvent (find a way around it/overcome) its design. (2.25)
High audit fees => important client in portfolio
facts
What are 4 rules to avoid impairment of independence? (2.30)
- Prohibit non-audit services
- Cooling down period (don’t really understand)
- Firm/partner rotation
- Monitoring mechanism
Who rely on audited FS? (2.31) Around 10 are named below
- The client, actual and potential investors, vendors, banks, employees, customers, supervisory boards, unions, the government, …
What are the 2 types of audit quality safeguards? (2.31)
- Legal (via civil and criminal liability)
- Market (through reputational concerns)
What is the max duration period of audit engagements with possible derogations?
10
