Chapter 2: Objective of a Financial Statement Audit

Question 1

Financial Statement Audit

Answer 1

process of developing and communicating an opinion as to the material accuracy of financial statements

Question 2

Reasons Financial Statement Audits are Demanded

Answer 2

1) Publicly traded companies and companies that have public debt are required by SEC to have f/s audit, 2) Having audited f/s lowers risk for creditors/investors which ultimately lowers cost of capital, 3) Ensures accuracy of accounting records and to detect and deter employee fraud

Question 3

Management override

Answer 3

someone has the ability to fire you, likely also have ability to get you to override the system

Question 4

Users of financial statements

Answer 4

Investors, Lenders/Creditors, Other Stakeholders

Question 5

Why don’t investors trust management to provide correct f/s?

Answer 5

Managers have different incentives than investors and often may have reason to try and trick investors

Question 6

What is the main threat to f/s accuracy?

Answer 6

Management manipulation of the f/s

Question 7

What is the objective of a f/s audit

Answer 7

to provide users of the financial statements reasonable assurance that the f/s are free from material misstatement

Question 8

Reasonable assurance

Answer 8

high, but not absolute, level of assurance that f/s are free from material misstatement

Question 9

When does a misstatement occur?

Answer 9

when information does not conform to the established evaluative criteria (GAAP)

Question 10

Types of misstatements

Answer 10

Unintentional and Intentional

Question 11

Unintentional Misstatements

Answer 11

result of human or systematic error and often referred to as errors, smaller and less significant

Question 12

Intentional Misstatements

Answer 12

when management intentionally misstates f/s generally to make company appear to be in better financial condition than reality, larger and more significant

Question 13

Materiality

Answer 13

Significance of a misstatement

Question 14

What is the general rule to determine whether misstatement is material or not?

Answer 14

Whether the given misstatement would affect or influence decision of reasonable decision maker

Question 15

Quantitative Materiality

Answer 15

how large a misstatement would have to be to be considered material

Question 16

Qualitative Materiality

Answer 16

circumstances when the nature of a misstatement makes misstatement material

Question 17

What do audits test?

Answer 17

Validity of the f/s assertions and provide f/s users with reasonable assurance that assertions being made in the f/s are free from material misstatements

Question 18

Management’s assertions

Answer 18

implicit representations management makes when they explicitly state that their f/s conform to GAAP

Question 19

Categories of management assertions

Answer 19

Transactions, Account Balances, and Disclosures

Question 20

Transactions

Answer 20

economic events that underlie numbers reported in f/s

Question 21

Account Balances

Answer 21

Asset, Liability, and equity balances on balance sheet

Question 22

Disclosures

Answer 22

information communicated in footnotes to f/s

Question 23

Assertions Related to Transactions

Answer 23

1) Occurrence - all transactions that have been recorded actually occurred, 2) Completeness - all transactions that have occurred, have been recorded, 3) Cut-off - transactions have been recorded in the correct accounting period, 4) Classification - transactions have been recorded in the proper accounts, 5) Accuracy - transactions have been recorded at the correct amount

Question 24

Assertions Related to Account Balances

Answer 24

1) Existence - all asset, liability, and equity accounts that have been recorded actually exist, 2) Completeness - all asset, liability, and equity accounts that exist have been recorded, 3) Rights & Obligations - company owns rights to all recorded assets and all recorded liabilities represent obligations of company, 4) Valuation and Allocation - all accounts have been properly valued and costs are properly allocated between balance sheet and income statement

Question 25

Assertions Related to Disclosures

Answer 25

1) Occurrence - all disclosed transactions and events actually occurred, 2) Completeness - all disclosures that should have been included have been included, 3) Understandability - disclosed information is understandable, 4) Rights & Obligations - disclosed events pertain to entity, 5) Valuation & Allocation - disclosed information is accurate and at appropriate amounts

Question 26

What do auditors do?

Answer 26

Gather audit evidence through a variety of audit procedures to test the validity of management’s assertions

Question 27

Auditor’s Report

Answer 27

end result of the audit, states the auditor’s opinion about the material accuracy of the f/s

Question 28

Types of Opinions

Answer 28

Unqualified, Modified Unqualified, Qualified, Adverse, Disclaimer of Opinion

Question 29

Unqualified Opinion

Answer 29

f/s free from material misstatement in compliance with GAAP

Question 30

Modified Unqualified Opinion

Answer 30

f/s free from material misstatement but feel need to bring specific information to attention of f/s users

Question 31

Qualified Opinion

Answer 31

material misstatement exists in one area of f/s, due to scope limitation or known departure from GAAP

Question 32

Adverse Opinion

Answer 32

f/s as a whole are so materially misstated that f/s should not be relied upon

Question 33

Disclaimer of Opinion

Answer 33

unable to express an opinion on f/s due to severe scope limitation or when determine auditors lack independence with respect to audited company