Chapter 5 Flashcards
[RC 5-1]
What does the term “those charged with governance” refer to in auditing standards?
Those who ate charged with governance are corporation’s Board of Directors and its management, who are responsible for its operations and accountable to the stakeholders.
[RC 5-3]
List the ethical requirements that must be met to perform an independent audit engagement.
Independent auditors must follow professional ethics codes that require them to be independent of the auditee, to act with integrity, to have the necessary skills in accounting and auditing, to apply their skills carefully and dutifully in the specific circumstances of the company and its financial statements, and to comply with the GAAS.
These requirements are enforced to protect the interest of the public. Before an audit engagement can even be started, the people who are performing need to check whether they can comply with all the ethical standards that apply to the engagement.
If not, they cannot accept the engagement.
[RC 5-5]
What are the key factors involved in determining whether an auditor, or audit firm, can except an audit engagement?
What difference arises between a continuing audit engagement and a new engagement?
The final decision is made by audit firm partners, who are the most senior people in the firm. The following aspects always need to be understood before an audit engagement as excepted, whether new or continuing.
The auditor, at the audit firm and\or individual level, has to determine whether independence and other professional ethical requirements can be met.
Does the auditor have the confidence and available resources to comply with a GAAS for this company? Are those charged with governance willing and able to accept the responsibilities to fairly present the financial statements? Does management have reasonable internal controls to support fair presentation of the financial statements? Are there any exceptional risks to the auditor of becoming associated with the company and providing assurance on its financial statements?
The main difference is there may have been a different auditor in the previous year. In this case, the two auditors need to communicate with each other and inquire if the predecessor auditor knows of any reasons the new auditor should not accept engagement.
Considered a “professional curtesy”
[RC 5-8]
Why do the professional ethics codes require that a successor auditor communicate with a predecessor auditor?
The professional ethics codes requirements allow a successor to find out if the predecessor auditor knows of any reasons the new auditor should not except the engagement.
If, for example, the predecessor auditor was dismissed because the company’s management refused to follow GAAP, this indicates the management may be “opinion shopping” – looking for a more pliable auditor who won’t prevent management from using aggressive financial reporting policies.
This is not a desirable situation for the successor auditor, so it gives a warning that this company may not be a good choice as a new audit client. By ensuring auditors do not take on undesirable clients, the professional ethics requirements help to keep the quality of audits high.
[RC 5-9]
What is an audit engagement letter? What information does it contain? What is its purpose?
It is a letter from the auditor addressed to those charged with governance of the auditee company.
When a decision is made to accept an audit engagement, the auditor must obtain an engagement letter signed by the responsible parties at the client company.
The engagement letter establishes mutual agreement with the client on the terms of the engagement. This agreement is like a contract between the auditor and those charged with governance of the auditee.
It includes a description of the nature of the audit, managements responsibilities for fair presentation of the statements, for implementing effective internal controls and to provide all information and representations that the auditor needs to complete the engagement.
The letter also describes the auditors responsibilities to conduct the audit in accordance with the GAAS, and sets out the type of audit opinion and report expected to be issued at the end of the engagement.
[RC 5-10]
What are the three main steps in the audit process?
The three main steps in the financial statement audit process are:
i) risk assessment
ii) responding to the assessed risks
iii) concluding and reporting
[RC 5-15]
What are analytical procedures? How are they useful in the risk assessment step of an audit?
Analytical procedures include techniques such as comparative analysis of the financial ratios from year to year, vertical analysis, and comparison to industry averages.
To be effective, the auditor should form expectations about the relations that should appear in the draft [unaudited] Financial statements. Then the analysis results can be compared to expectations to highlight questionable numbers and relations in the financial statements. These questionable relations indicate areas with higher risk of misstatement.
The analysis findings would be followed up with further investigation and inquiries of management.
[RC 5-16]
What does the term materiality mean in auditing?
It refers to a monetary amount that auditors believe financial statement users would find significant, or material, to their decision-making.
[RC 5-17]
Why is determining the materiality level one of the first and most important decisions an auditor must make?
It is one of the first and most important audit decisions because it focusses on the needs of financial statement users, so it is a practical starting point for determining what is important to focus on and planning how to do the audit.
Since auditors cannot provide absolute assurance that financial statements are totally accurate, a user based materiality level ensures they will have the greatest chance of meeting users needs for precise information with lower information risk.
[RC 5-18]
Explain how materiality as a user based decision of the auditor.
Auditors set the materiality level based on what they believe financial statement users would find significant to their decision-making.
It is the most practical way to decide what is important while planning how to do the audit.
Users of for-profit businesses are interested in the profitability so they can assess the return on their investments. Qualitative considerations are also very important for determining what is material, since some facts could be very significant to users decisions even if the monetary amount involved is fairly small.
Auditors must always consider the discovery of fraud or illegal bribes by management to be material, since these facts reflect a lack of management integrity they could have very negative consequences for the future health of the company.
[RC 5-21]
What qualitative considerations are related to the concept of materiality in auditing? Why are qualitative factors more important than the quantitative materiality level decision?
Qualitative considerations about what is material are more important than quantitative rules. Some facts auditors discover to be very significant to users decisions even if the monetary amount involved is fairly small.
Fraud or brides by management are always considered material because they reflect the lack of management integrity and could have negative consequences for the future health of the company.
They are also more important at the conclusion step of the audit process. Even if the accumulated misstatements are less than the quantitative ceiling, the auditor still has to consider if management bias exists or attempts to conceal negative trends.
If there is a concern on qualitative grounds, the auditor would still have to conclude the financial statements are materially misstated. So the qualitative factors always overrule the quantitative results informing the overall audit conclusion.
[RC 5-22]
Why do auditors need an understanding of the business environment and operations of an auditee company? What are examples of a business is environmental and operating risks?
Their understanding of the business is needed to identify the operating and environmental risks that management faces, and the strategies and controls management use to reduce these risks.
If they don’t have appropriate strategies or good controls to manage and reduce risk to a reasonable level, significant risks can arise.
These risks can affect financial statements if they are not properly presented so users are aware.
Environmental risks include external factors like industry competition, technology changes, regulation, interest rates, supply chain uncertainties, and market price changes.
Operating risks can arise from internal factors, such as inappropriate strategy, weak management systems and controls, and financial uncertainties about whether the company can survive.
[RC 5-29]
What is included in an overall audit strategy in GAAS? What is the main purpose of this planning documentation?
The overall audit strategy is a planning document required by GAAS, that records all the auditors decisions.
That summarizes the main characteristics of the engagement and the key audit areas that will need to be addressed. It will set out decisions relating to the audit staff to be assigned to different audit areas, what experience they need to have, where and when the audit work will need to be done, and a plan for doing the audit procedures required by GAAS.
This planning document serves as a guide to the audit team in performing the audit. The overall audit strategy and planning documents, and other key audit documentation, are kept in the audit files as a record that the auditors work to show that they have used due care.
[RC 5-34]
What types of companies need audited financial statements? What type of companies often do not need to be audited?
Publicly listed companies need to be audited according to the securities regulations that apply to them. Private companies often don’t need audits.
Shareholders of smaller corporations can waive a statutory audit requirement. In some cases, the company stakeholders, such as major shareholders or lenders, may require an audit of the financial statements even if it could be waived.
[RC 5-37] 1 of 2
What sources of information can an auditor use in deciding whether to except an audit engagement?
An auditor can use the following sources of information to help decide whether to accept a new audit auditee:
Financial information prepared by the prospective auditee [annual reports to shareholders, interim financial statements, securities registration statements, reports to regulatory agencies]
Inquiries directed to the prospects business associates [Banker, legal counsel, underwriter, other persons like customers or suppliers]
Predecessor auditor, if any, communication, re: [Integrity of management, disagreements with management]
Analysis: special or unusual risk related to the prospect, need for special skills like computer or industry experience.
Internal search for relationships that would compromise independence.
