Chapter 3 Flashcards
Information on each workpaper
Name, date, purpose, page number
Procedures performed and conclusions reached by the auditor
(Evidence that the auditor followed GAAS, Audit Tick Mark Legend)
Preparer’s and Reviewer’s initials
5 Activities of an Audit
- Obtain (or retain) Engagement
- Engagement Planning
- Risk Assessment
- Audit Evidence
- Reporting
Pre-Engagement Activities
(Obtain (or retain) Engagement)
Client acceptance or continuance
- Communication between predecessor and prospective auditors
- Compliance with Independence and Ethical Requirements
- Engagement Letters
Communication between predecessor and prospective auditors
ATTEMPT to communicate is required
Issues should be discussed
IF the client permits… what issues should be discussed between the predecessor and prospective auditors?
- Basic information regarding issues that reflect directly on the integrity of management
- Disagreements about accounting principles or audit procedures
- Communications the predecessor auditors gave the former client about fraud, illegal acts, and internal control recommendations
- The predecessor auditors’ understanding about the reason for change of auditors (particularly about the predecessor auditors’ termination)
What does the responsibilities principle require auditors to do?
Comply with the appropriate ethical requirements for each audit engagement
Independence in Appearance
Relates to the perceptions of auditors’ independence (auditor needs to be objective)
A lack of independence can result in…
Disciplinary action by regulators and/or professional organizations and litigation by those who relied on the financial statements
Engagement Letter
“Establishes an understanding with the Entity”
Outlines the responsibilities of the client and the auditor
Formal contract that protects both parties
(Management is supposed to provide things in a timely manner)
Audit Plan
- How are you going to gather sufficient appropriate evidence on which to base the opinion on the financial statements?
- Auditor needs to develop and document a plan that describes the procedures to be performed to assess the risk of material misstatement at the financial statement and assertion level
How does an auditor mitigate risks?
The auditor must carefully plan the nature, timing, and extent of control tests and substantive tests
Staffing the Audit Engagement
- Audit engagement partner
- Audit manager
- Audit staff
- IT audit specialist (more likely for public companies)
- Tax partner/manager/senior
- Quality assurance partner
Why are more experience staff members typically assigned to new clients, clients with complex transactions, and public clients?
SEC regulations for public, difficulty, shareholder’s interest, legal liability (litigation risk)
Considering the work of internal auditors
Must obtain an understanding of a client’s internal audit department and its work
Who has to have internal auditors?
Companies traded on the NYSE (not required for NASDAQ)
Audit efficiency of working with internal auditors
How can I use the internal audit as an external auditor to make my job as efficient as possible?
Prior to using work of internal auditors…
assess the internal auditors’ objectivity and competence
Rely less (or not at all) in risky areas (materiality, risk, judgement)
Should you delegate tasks that require extensive professional judgement to internal auditors?
No
What are the two ways to use internal audits?
Reliance: external auditors use internal auditors’ wok
Direct assistance: external auditors use the internal auditors to work (employee is kind of on “loan”)
Internal audits are used in what kind of situations?
low risk and straight-forward
Use of Auditor-Employed Specialists
- Specialists are persons skilled in fields other than accounting and auditing (actuaries, geologists, etc.) and who are not members of the audit team
- Auditors must know about the specialist’s professional qualifications, experience, and reputation
- Specialists should be unrelated to the client (objectivity)
- Auditors should evaluate the work of specialists
- Specialists are typically not referred to in the audit report (the auditor is taking responsibility for the specialists)
Use of Company-Employed Specialists
- Must consider objectivity and competence of the company specialist
- Must evaluate the work of the company specialist, including evaluating data, methods, or assumptions made
- The extent of the evaluation of the work is contingent on the risk of material misstatement in the area, the significance of the work to the auditor’s conclusion, and the objectivity and competence of the company specialist
Time Budget
Used to maintain control of the audit by identifying problem areas early on in the engagement, thereby ensuring that the engagement is completed on a timely basis
Interim Audit Work
Refers to procedures performed several weeks or months before the balance sheet date
(work used before year-end)
Year-End Audit Work
Refers to procedures performed shortly before or after the balance sheet date
(for fiscal year end 12/31 - December until filed (March))
Materiality
Refers to an amount (or transaction) that would influence the decisions of users - an amount (or event) that would make a difference. the emphasis is on the user, rather than management or the audit team.
The United States Supreme Court interpretation of materiality is that a fact is material if…
there is a substantial likelihood that the…fact would have been viewed by the reasonable investor as having significantly altered the “total mix” of information made available
The determination of materiality requires…
professional judgement
What establishes materiality for the financial statements as a whole?
Overall/Planning Materiality
What is used as a basis for designing audit tests?
Tolerable misstatement or performance materiality
When is materiality used during the audit?
Up front to design tests and at the end to evaluate
Which is more work?
- $25 billion within a $25 million window OR
- $100 million within a $25 million window
1 - $25 billion within a $25 million window
you have to reduce risk to 10% vs. 25%
The quantitative basis for materiality is a percentage of…
- Income/loss before taxes (most common)
- Income from continuing operations
- 3 year average income
- Total assets
- Net assets
- Total revenues
- Gross profit
- Total equity
(chose an account that would be important to investors)
The qualitative amounts may be adjusted lower for qualitative factors such as…
- Material misstatements in prior years
- High risk of fraud
- Potential loan covenant violations
- High market pressures
- Volatile business environment
- Higher than normal risk of bankruptcy
Tolerable misstatement
the amount of overall materiality allocated to an account or class of transactions
(aka “performance materiality”)
When the audit evidence is gathered, the auditor:
- Aggregates misstatements from each account (including known and likely misstatements)
- compares the account-level misstatements to tolerable misstatement
- compares the aggregate misstatement to overall materiality
- if the aggregate misstatement is less than overall materiality and if accounts are not misstated by more than tolerable misstatement, the auditor can conclude (quantitatively) that the financial statements are fairly presented; if not, an adjustment should be made
Eilifsen and Messier report the following qualitative factors are included when evaluating misstatements:
- potential effect on trends, especially trends on profitability
- will the misstatement change a loss into income or vice versa?
- effect on compliance with loan covenants
- will the misstatement increase management’s compensation?
What are the 3 steps of materiality?
- Determine overall materiality
- Determine tolerable misstatement
- Evaluate audit findings
You must “accumulate” or “post” misstatements except those that are…
“clearly trivial”
Uncorrected misstatements must be…
communicated to the audit committee or those charged with governance
The auditor must evaluate whether uncorrected misstatements are…
Material, individually or in combination, with other misstatements
What is the most common benchmark for overall materiality for public companies?
5% of income before taxes
What is the most common benchmark for tolerable misstatement?
50-75% of overall materiality
What is the most common benchmark for clearly trivial misstatements?
3-5% of overall materiality
All misstatements that are not clearly trivial are…
posted to a summary of unadjusted misstatements
(posted to a document that auditors give to the company)
Auditors use audit procedures for 3 purposes including:
- To gain an understanding of the client and the risks associated with the client (risk assessment procedures)
- To test the operating effectiveness of client internal control activities (test of controls)
- To produce evidence about management’s assertions related to the amounts and disclosures in a client’s financial statements (substantive procedures)
Substantive Audit Plan
Should contain a list of audit procedures for gathering evidence related to the relevant assertions identified for the significant financial statement accounts and disclosures of an audit client
Two ways to conduct substantive tests:
- Substantive analytical procedures
- Test of details
Substantive Tests Map To…
assertions
Existence/Occurrence
Do the assets recorded really exist?
Valuation and Allocation
Are the receivables valued correctly?
Example of Existence/Occurrence
Procedure: inspect the assets
Evidence: physical presence of the assets
Example of Valuation and Allocation
Procedure: reperform the client-prepared aging schedule
Evidence: client-prepared aging schedule
What are the types of procedures to gather evidence?
- Inspection of records and documents (vouching, tracing, scanning)
- Inspection of tangible assets
- Observation
- Inquiry
- Confirmation
- Recalculation
- Reperformance
(All of the above are Test of Details) - Analytical Procedures
(Analytical Procedures)
Vouching
Auditor selects an item of financial information and follows its path BACK through the processing steps to its origin
Example of Vouching
Sample journal entries from the sales journal and vouch to sales invoice, shipping documents, and customer purchase order
“Did all recorded sales occur?”
What do you test for when you vouch?
EXISTENCE/OCCURRENCE not completeness
Tracing
Auditor selects a basic source document and follows its processing path FORWARD to find its final recording in a summary journal or ledger
“Were all shipments made to customers actually recorded as sales?”
Example of Tracing
Sample shipping documents and trace to sales journal
What do you test for when you trace?
COMPLETENESS not existence/occurrence
Scanning example
A COGS should be a debit
Look through all COGS entries for any credit entries (these would be outliers and would point you to where you need to spend time verifying)
Inspection of physical assets
Physically go and look
Observation
Watch someone do something
Inquiry
Ask management, etc.
Confirmation
The process of obtaining a representation of information or of an existing condition directly from a 3rd party
The reliability of evidence obtained through confirmations is directly affected by factors such as…
- The form of the confirmation
- Prior experience with the entity
- The nature of the information being confirmed
- The intended respondent
Examples of confirmation
- A bank can confirm a cash balance
- A customer can confirm an AR balance
Analytical Procedures
Evaluations of financial information made by a study of plausible relationships among both financial and non financial data
How are expectations relevant to analytical procedures?
Auditors must compare an expectation to a recorded balance (an expectation that was made BEFORE)
Are analytical procedures required?
They are required in the planning phase and at the end of the audit - they are optional to use as substantive evidence
Information used in analytical procedures
Auditors should use independent, reliable information for analyses. The sources of information for the analytical procedures are very important. Auditors must gain comfort over the information used to develop expectations during analytical procedures.
Audit Documentation
The written record of the basis for the auditor’s conclusions that provides the support for the auditor’s representations, whether those representations are contained in the auditor’s report or otherwise
Audit Documentation Requirements
Audit documentation should be prepared in sufficient detail to enable an EXPERIENCED AUDITOR having no previous connection with the engagement to:
- Understand the nature, timing, extent, and results of procedures, evidence obtained and conclusions reached
- Determine who performed the work, date of work, reviewer and date of review
Audit Documentation Requirements
The planning documentation must include a listing of…
- Each significant account and disclosure in the client’s financial statements and
- Each relevant financial statement assertion related to the significant accounts and disclosures
Audit Documentation Requirements
Audit documentation should provide a clear link to significant findings of issues and…
- Demonstrate compliance with professional standards
- Support basis for conclusions for each relevant assertion
- Document that accounting records agree with financial statements
An account or disclosure is considered SIGNIFICANT if…
there is a reasonable possibility it could contain a material misstatement
An assertion is considered RELEVANT if….
there is a reasonable possibility it could contain a material misstatement
Document retention
Documentation must be retained 7 years from report release date (if no report - from last day of fieldwork)
Documentation that needs to be retained: discussion and subsequent resolution of differences in professional judgements among team members
All documentation must be finalized within 45 days of the audit report’s release date
