Chapter 2: Objective of a Financial Statement Audit Flashcards
Financial Statement Audit
process of developing and communicating an opinion as to the material accuracy of financial statements
Reasons Financial Statement Audits are Demanded
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
Management override
someone has the ability to fire you, likely also have ability to get you to override the system
Users of financial statements
Investors, Lenders/Creditors, Other Stakeholders
Why don’t investors trust management to provide correct f/s?
Managers have different incentives than investors and often may have reason to try and trick investors
What is the main threat to f/s accuracy?
Management manipulation of the f/s
What is the objective of a f/s audit
to provide users of the financial statements reasonable assurance that the f/s are free from material misstatement
Reasonable assurance
high, but not absolute, level of assurance that f/s are free from material misstatement
When does a misstatement occur?
when information does not conform to the established evaluative criteria (GAAP)
Types of misstatements
Unintentional and Intentional
Unintentional Misstatements
result of human or systematic error and often referred to as errors, smaller and less significant
Intentional Misstatements
when management intentionally misstates f/s generally to make company appear to be in better financial condition than reality, larger and more significant
Materiality
Significance of a misstatement
What is the general rule to determine whether misstatement is material or not?
Whether the given misstatement would affect or influence decision of reasonable decision maker
Quantitative Materiality
how large a misstatement would have to be to be considered material
Qualitative Materiality
circumstances when the nature of a misstatement makes misstatement material
What do audits test?
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
Management’s assertions
implicit representations management makes when they explicitly state that their f/s conform to GAAP
Categories of management assertions
Transactions, Account Balances, and Disclosures
Transactions
economic events that underlie numbers reported in f/s
Account Balances
Asset, Liability, and equity balances on balance sheet
Disclosures
information communicated in footnotes to f/s
Assertions Related to Transactions
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
Assertions Related to Account Balances
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
Assertions Related to Disclosures
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
What do auditors do?
Gather audit evidence through a variety of audit procedures to test the validity of management’s assertions
Auditor’s Report
end result of the audit, states the auditor’s opinion about the material accuracy of the f/s
Types of Opinions
Unqualified, Modified Unqualified, Qualified, Adverse, Disclaimer of Opinion
Unqualified Opinion
f/s free from material misstatement in compliance with GAAP
Modified Unqualified Opinion
f/s free from material misstatement but feel need to bring specific information to attention of f/s users
Qualified Opinion
material misstatement exists in one area of f/s, due to scope limitation or known departure from GAAP
Adverse Opinion
f/s as a whole are so materially misstated that f/s should not be relied upon
Disclaimer of Opinion
unable to express an opinion on f/s due to severe scope limitation or when determine auditors lack independence with respect to audited company
