Chapter 3 Terms

Question 1

How does proper planning benefit the auditor?

Answer 1

1) Identify and devote proper attention to significant areas of the audit
2) Identify and resolve potential problems on the audit
3) Property organize and manage the audit engagement so that it is performed in an effective and efficient manner.
4) Assist in the selection of engagement team members with appropriate levels of capabilities and competence.
5) Facilitate the supervision of engagement team members, and
6) Assist in coordination of work done by specialists and auditors of components of the entity.

Question 2

What are the phases of an audit that relate to audit planning?

Answer 2

1) Client Acceptance and Continuance
2) Preliminary Engagement Activities
3) Plan the Audit

Question 3

What does a public accounting firm have to consider before accepting a new client?

Answer 3

The firm determines it:
1) Has the capabilities to perform the engagement.
2) Complies with legal and relevant ethical requirements.
3) Has considered the integrity of the client.

Question 4

When we refer to a firm determining the integrity of the client, we are referring to:

Answer 4

The auditors need to determine:
1) The identity and business reputation of the client’s principal owners, key management, and those charged with governance.
2) The nature of the client’s operations, including its business practices.
3) Information concerning the attitude of the client’s principal owners, key management, and those charged with governance toward such maters as internal control or aggressive interpretation of accounting standards.
4) Indications of an inappropriate limitation in the scope of the work.
5) Indications that the client might be involved in money laundering or other criminal activities.
6) The reasons for the proposed appointment of the firm and non-reappointment of the previous firm.

Question 5

What are the sources of information for auditors when they are evaluating a prospective client?

Answer 5

1) Communicate with existing or previous providers of professional accountancy services to the client, in accordance with relevant ethical requirements.
2) Inquiry of other firm personnel or third parties, such as bankers, legal counsel, and industry peers.
3) Background searches of relevant databases.

Question 6

What types of inquiries should the successor auditor make of the predecessor auditor?

Answer 6

1) Information that might bear on the integrity of management.
2) Information regarding identified or suspected fraud and matters involving noncompliance with laws and regulations.
3) Disagreements with management about accounting policies, auditing procedures, or other similarly significant matters.
4) Communications to audit committees or others with equivalent authority and responsibility regarding fraud, illegal acts by clients, and internal-control-related matters.
5) The predecessor auditor’s understanding as to the reasons for the change of auditors.
6) The predecessor auditor’s understanding of the nature of the company’s relationships and transactions with related parties and significant unusual transactions.

Question 7

What are the three preliminary engagement activities?

Answer 7

1) Determining the audit engagement team requirements,
2) Ensuring that the audit team and audit firm are in compliance with ethical and independence requirements, and
3) Establishing an understanding with the entity.

Question 8

Factors that should be considered in determining staffing requirements include:

Answer 8

1) Engagement size and complexity,
2) Level of risk
3) Any special expertise
4) Personnel availability
5) Timing of the work to be performed.

Question 9

The terms of the engagement, which are documented in the engagement letter, should include:

Answer 9

Should include:
1) The objectives of the engagement
2) Management’s responsibilities
3) The auditor’s responsibilities
4) The limitations of the engagement.

Question 10

In establishing an understanding with the client, three topics should be discussed:

Answer 10

1) The engagement letter.
2) Using the work of the internal auditors, and
3) The role of the audit committee.

Question 11

Engagement Letter

Answer 11

A letter that formalizes the contract between the auditor and the entity and outlines the responsibilities of both parties.

Question 12

When the entity has an internal audit function (IAF), the auditor may:

Answer 12

1) Use the work of the IAF to obtain audit evidence and/or
2) Use internal auditors to provide direct assistance in conducting the audit under the direction, supervision, and review of the external auditor.

Question 13

The extent to which auditors may be able to use the work of the IAF in obtaining audit evidence depends on:

Answer 13

1) The level of competency of the internal audit function.
2) Whether the internal audit function’s organizational status and relevant policies and procedures adequately support the activity of the internal auditors.
3) Whether the internal audit function applies a systematic and disciplined approach, including quality control.

Question 14

Internal Audit Function (IAF)

Answer 14

An independent, objective assurance and consulting activity designed to add value and improve an organization’s operations. It helps an organization accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control, and governance processes.

Question 15

Audit Committee

Answer 15

A subcommittee of the board of directors that is responsible for the financial reporting and disclosure process.

Question 16

Under Section 301 of the Sarbanes-Oxley Act, the audit committee of a public company has the following requirements:

Answer 16

1) Each member of the audit committee must be a member of the board of directors and shall be independent of the company (i.e., does not have a material relationship with the company besides the board of director appointment).
2) The audit committee is directly responsible for the appointment, compensation, and oversight of the work of any registered public accounting firm employed by the company.
3) The audit committee must pre approve all audit and nonaudit services provided by its auditor.
4) The audit committee must establish procedures for the receipt, retention, and treatment of complaints received by the company regarding accounting, internal control, and auditing.
5) Each audit committee member must have the authority to engage independent counsel or other advisors, as it determines necessary to carry out its duties.

Question 17

Audit Strategy

Answer 17

The auditor’s plan for the expected conduct, organization, and staffing of the audit.

Question 18

Audit Plan

Answer 18

This is more detailed than the audit strategy. In this, the auditor documents a description of the nature, timing, and extent of the planned audit procedures to be used in order to comply with auditing standards. Basically, it should consider how to conduct the audit in an effective and efficient manner.

Question 19

Steps included in formulating the auditing strategy and plan include:

Answer 19

1) Assess business risk.
2) Establish materiality
3) Consider multi locations
4) Assess the need for specialists
5) Consider violations of laws and regulations
6) Identify related parties
7) Conditioner additional value-added services.
8) Document the overall audit strategy, audit plan, and prepare audit programs.

Question 20

Tolerable Misstatement

Answer 20

The amount of overall materiality used to plan and perform audit procedures at the account or disclosure level.

Question 21

Specialist

Answer 21

A person or firm possessing special skill or knowledge in a field other than accounting or auditing, whose work in that field is used by the auditor to assist the auditor in obtaining sufficient appropriate audit evidence. An auditor’s specialist may be either an auditor’s employed (internal) specialist or an auditor’s engaged (external) specialist.

Question 22

What are examples of ‘specialties’ that an auditor can have?

Answer 22

Finance, valuation, pension, and legal issues.

Question 23

Illegal Acts

Answer 23

A violation of laws or government regulations.

Question 24

Some sources of information on related parties include:

Answer 24

1) Management
2) Minutes of the board of director meetings.
3) Conflict-of-interest statements from management and others.
4) Financial and reporting information provided to creditors, investors, and regulators.
5) Contracts or other agreements (including side agreements that may not be formally documented between customers and vendors, and management).
6) Contracts and other agreements representing significant unusual transactions.

Question 25

Audit Procedures

Answer 25

Specific acts performed as the auditor gathers evidence to determine if specific audit objectives are being met.

Question 26

Risk Assessment Procedures

Answer 26

The audit procedures designed and performed to identify and assess the risks of material misstatement, whether due to fraud or error, at the financial statement and assertion levels.

Question 27

What types of activities do risk assessment procedures include?

Answer 27

Includes inquiries of management and others, preliminary analytical procedures, and observation and inspection.

Question 28

Test of Controls

Answer 28

Audit procedures performed to test the operating effectiveness of controls in preventing, or detecting and correcting, material misstatements at the relevant assertion level.

Question 29

What audit procedures are examples of tests of controls?

Answer 29

1) Inquiries of appropriate management, supervisory, and staff personnel.
2) Inspection of documents, reports, and electronic files.
3) Observation of the application of specific controls.
4) Walkthroughs, which involve tracing a transaction from its origination to its conclusion in the financial statements through a combination of audit procedures, including inquiry, observation, and inspection.
5) Reperformance of the application of the control by the auditor.

Question 30

Substantive Procedures

Answer 30

Audit procedures performed to test material misstatements in an account balance or disclosure component of the financial statements.

Question 31

What are the two categories of substantive procedures?

Answer 31

1) Tests of detail
2) Substantive analytical procedures.

Question 32

What are the two types of Test of Details?

Answer 32

1) Substantive tests of transactions and
2) Tests of details of account balances and disclosures.

Question 33

Substantive Tests of Transactions

Answer 33

Tests to detect errors or fraud in individual transactions.

Question 34

Test of Details of Account Balances and Disclosures

Answer 34

Substantive tests that concentrate on the details of items contained in the account balance and disclosure.

Question 35

Analytical Procedures

Answer 35

Evaluations of financial information made through analysis of plausible relationships among both financial and nonfinancial data.

Question 36

Dual-Purpose Test

Answer 36

Tests of transactions that both evaluate the effectiveness of controls and detect monetary errors.

Question 37

Audit Data Analytics (ADA)

Answer 37

Using analysis, modeling, and visualization to discover and analyze patterns, anomalies, and other information in data in the context of the audit.

Question 38

Tolerable Misstatement (Performance Materiality)

Answer 38

The amount of the overall materiality that is used to establish a scope for the audit procedures for the individual account balance or disclosures.

Question 39

Misstatements

Answer 39

A difference between the amount, classification, presentation, or disclosure of a reported financial statement item and the amount, classification, presentation, or disclosure that is required for the item to be presented fairly in accordance with the applicable financial reporting framework.

Question 40

How does the PCAOB judge materiality?

Answer 40

They focus mainly on protecting “investors” and uses the Supreme Court of the US’ interpretation of the federal securities law, which states 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.”

Question 41

How does ASB judge materiality?

Answer 41

This provides further guidance to auditors in assessing the effects of a misstatement on the economic decisions of users and how users could reasonably be expected to be influenced in making economic decisions.

Question 42

What assumptions are made about ‘Users’?

Answer 42

1) Have a reasonable knowledge of business and economic activities and accounting and a willingness to study the information in the financial statements with reasonable diligence.
2) Understand that financial statements are prepared, presented, and audited to levels of materiality.
3) Recognize the uncertainties inherent in the measurement of amounts based on the use of estimates, judgment, and the consideration of future events.
4) Make reasonable judgments based on the information in the financial statements.

Question 43

What are the three steps in applying Materiality?

Answer 43

Step 1: Determine overall materiality.
Step 2: Determine tolerable misstatement.
Step 3: Evaluate audit findings.

Question 44

Overall Materiality (Planning Materiality)

Answer 44

The maximum amount by which the auditor believes the financial statements could be misstated and still not affect the decisions of users.

Question 45

If individual unadjusted misstatements are less than tolerable misstatement, but aggregate to an amount greater than materiality, then:

Answer 45

1) The audit client will need to make adjustments to decrease the unadjusted misstatements below materiality
2) The auditor will need to perform more testing; and/or
3) The auditor will issue a qualified or adverse opinion.