FINAL EXAM COPY Flashcards
Purpose: To estimate characteristic of group without complete examination of all items constituting the group.
Sampling
Definition: A technique or methodology for (1) Determining Sample Size (2) selecting items to be tested and of (3) evaluating the results of the test on the basis of mathematical laws of probability.
Statistical Sampling
Definition: Technique for selecting sample size that is not calculated. Ex: “Go pick a few”
Non-Statistical Sampling
Sampling Technique: Selection of a sample from a population of items in such a manner that each item in the population has an equal chance of being chosen for examination. 1. Random number table or random number generators are generally used for applying this selection approach.
2. Population items must be numbered.
Random sampling
Sampling Technique: sample items are selected according to some predetermined fixed interval (selection of every nth item). The first sample item is selected at random thus establishing the sequential pattern. 1. Population items should be arranged in random order or the auditor should use multiple random starts.
2. Population items do not need to be numbered.
Systematic Selection
Sampling Technique: Population is divided into classes or strata which are more homogeneous than the population as a whole. 1. Generally used to control variability in the population and reduce sample size.
2. Enables auditor to relate sample selection to materiality.
Stratified Selection
risks due to factors not related to sampling. Failure to recognize error in a document or transaction or failure to apply appropriate audit procedures.
Nonsampling Risk
2 step process in sampling a population
Project population, adjust for Sampling Risk
Important Concepts: Concerned with “How Much” or Dollar Amounts – Primarily used in substantive testing
Record (or Dollar) Sampling
Important Concepts: Concerned with “How Many” – Used to “Test (Internal) Controls” – Are controls working?
Attribute Sampling
Risk of incorrect Acceptance: in a test of internal controls, it is the risk that the sample supports a conclusion that the control is operating effectively when, in fact, it is not operating effectively. Same as beta.
Type II – This is the one to AVOID.
Risk of incorrect Rejection: in a test of internal controls, it is the risk that the sample supports a conclusion that the control is not operating effectively when, in fact, it is operating effectively (same as alpha from your stat class).
Type I
Important Concepts: Risk that sample is not representative of the population.
Sampling Risk
Important Concepts: Risk that sample is not representative of the population. – Controlled by Sample Size
Sampling Risk
Important Concepts: Selection of every nth item in the population. Used where population items are not numbered
Systematic Selection
Important Concepts: Used to control variability of population and reduce sample size. Divide population into sub-groups reducing variability which is measured by Standard Deviation
Stratification
Important Concepts: Used to audit for OVERSTATEMENT. Used to estimate max amount of Error in population
Dollar Unit Sampling
Important Concepts: Used to measure and control sampling risk. Based on Mathematical Laws of Probability
Statistical Sampling
Sampling Theory: Uses attribute-sampling theory
Monetary-Unit Sampling (MUS)
Sampling Theory: Used for $’s rather than attributes
Monetary-Unit Sampling (MUS)
Sampling Theory: Commonly used to test accounts such as accounts receivable, loans receivable, investment securities, and inventory (all of which are assets)
Monetary-Unit Sampling (MUS)
What is the following factor’s relationship to sample size, Direct or indirect? Desired Confidence Level
Direct, as it decreases, sample size decreases and vice versa
What is the following factor’s relationship to sample size, Direct or indirect? Tolerable Deviation Rate
Inverse, as it decreases, sample size increases
What is the following factor’s relationship to sample size, Direct or indirect? Tolerable Deviation Rate
Inverse, as it decreases, sample size increases
Factors that drive sample size
a. Desired confidence or reliability level
b. Tolerable deviation rate (misstatement)
c. Expectations
Once the desired confidence level is established, the sample size is determine largely by what?
Precision - How much the tolerable error exceeds expected error
rate comes from our planned assessed lvl of control risk
Tolerable Deviation Rate
Two technological advances have reduced the number of times auditors need to apply sampling techniques to gather audit evidence:
- Development ofwell-controlled,automated accounting systems. 2. Advent of powerfulPC audit software todownload andexamine clientdata
All sample results must be adjusted for:
Sampling Risk
All sample results must be adjusted for sampling risk and compared to?
Top tier of confidence interval
Conditions that create the demand for audits:
Conflict of Interest, Consequence, Complexity and Remoteness
Conditions that create the demand for audits: conflict between an information preparer and a user can result in biased information production
Conflict of Interest
Conditions that create the demand for audits: information can have substantial economic consequences to a decision maker
Consequence
Conditions that create the demand for audits: expertise is often required for information preparation and verification
Complexity
Conditions that create the demand for audits: users are frequently prevented from directly assessing the quality of information.
Remoteness
What theory says people take information into account, use it wisely, do not systematically make mistakes
Rational expectations theory
What 3 things will principals do with the Agency Theory?
Expect divergent acts from agent, Estimate the impact of divergent acts, Adjust the agent’s compensation to reflect the cost of divergent acts
2 agency problems that raise agency costs with the Agency theory:
information asymmetry & divergent acts
What is the risk that the observed F/S ≠ True F/S?
Information Risk
Risk that relates to peculiarities of individual firm’s data
Firm specific (unsystematic risk)
Risk that relates to variability of market as a whole
Market related (systematic risk)
The basic argument is that management can share liability exposure with an auditor and share the cost.
The Insurance Hypothesis; We now have proportionate liability unless you knowingly violate the securities act!
What 3 things does the Information Hypothesis imply?
Reduces risk, Improves management decision making and trading profits
What has been the effects of PCAOB inspections on auditors and audit quality?
Appearance and Fact
FORM AP requires disclosure of:
Identify lead partner and identify other accounting firms that perform more than 5% of audit. If less than 5%, report number of firms providing less than 5%.
New audit reporting model:
Pass/Fail, CAMs, challenging, subjective, or complex auditor judgments (must be material, disclose how issue was addressed), and must address tenure with audit firm
CAMS
Any matter that was or required to be communicated to the AC
“…the likelihood that an auditor (1) detects and (2) reports a material misstatement.”
Audit Quality
Practitioners often define this based on adherence to GAAS.
Audit Quality
The inverse of acceptable audit risk (i.e., the likelihood that an auditor fails to modify the opinion on f/s that are materially misstated).
Audit Quality
Appearance vs. Fact
Competence in fact and independence in appearance
Situation where we can know (become aware of) the quality of an audit.
Past observation of: Client financial restatements, Client fraud, Investor’s/Creditor’s response to audited financial statements and Other business failures
Detection
This primarily deals with “competence”
Detection actual Identified Differences:
Large Firms have less litigation,
Compliance increases with firm size, Large Firms issue GC opinions more often
Detection perceived Identified Differences:
Higher audit fees for Large Firms, IPO Prices, Higher stock price issues
Which is more difficult? For a company to find a new auditor OR For an auditor to find a new client
Much more difficult for auditor to find a new client
Short Tenure Pros and Cons
Pro: Fresh Eyes. Con: Low client familiarity (billing hours)
Long Tenure Pros and Cons
Pros: Increase client specific expertise. Cons: Complacent & loose objectivity (aligning with management)
Determinants of Audit Quality
Profession, Audit Firm, Local Office, Audit Team and Individual
How does the profession promote audit quality?
Standard Setting, Code of Conduct, Inspections and Peer Review, Research, Legal Liability
What are some things about an individual firm (or an office of the firm) that might affect “actual” audit quality?
- Human resources – hiring & training. 2. Control Processes (Strong audit methodologies, Peer review, Client acceptance & continuance) 3. Industry Expertise 4. Tone at the Top
What are some things about the team that might influence actual audit quality?
Partner & Manager attention, Skepticism, Client Experience, Industry experience
Self-Serving Bias - Example aspects of accounting/auditing that amplify the problem:
Ambiguity in GAAP & GAAS, Attachment to client, Approval of biased judgments
Self-Serving Bias - Example aspects of human nature that amplify the problem:
Familiarity with client, Discounting of delayed consequences, Escalation – we explain away minor issues
A General Model of
Audit-Related Pressures and Their Effects:
Pressure –> Stress Response –> Outcome
Audit-Related Pressures: Anticipating having to justify one’s judgments and decisions to others.
Accountability
Audit-Related Pressures: The actual process of explaining a judgment or decision.
Justification
Audit-Related Pressures: Individuals knowing their performance is going to be evaluated.
Feedback
Audit-Related Pressures: Influence of peers.
Conformity
Audit-Related Pressures: Pressure to succeed relative to others.
Competition
Audit-Related Pressures: Pressure to follow superior’s instructions.
Obedience
Audit-Related Pressures: Yielding to client’s wishes or influences (whether appropriate or not).
Client
Audit-Related Pressures: The constraint on resources that can be allocated to accomplish a job.
Time Budget
Audit-Related Pressures: Having to perform a task by a specific point in time.
Time Deadline
Audit-Related Pressures: Having too much to do.
Quantitative Overload
Audit-Related Pressures: Too complex a task to perform.
Qualitative Overload
Audit Quality is consistent with:
Earnings Quality (normally the deviation of net income and operating cash flow)
How might variable audit quality play a role under each theory for the demand for audits?
essayish ?
Most legal suits come from _____
Clients
Higher dollar amount suits from from ______
3rd party class action lawsuits
Class of law: Case law developed by judges
Common Law
Class of law: Written law enacted by the legislative branch of government
Statutory Law
Definition: When the client or auditor fails to meet the terms and obligations established in the engagement letter
Breach of Contract
Definition: Actions taken with the knowledge and intent to deceive
Fraud
Definition: An extreme, flagrant, or reckless departure from professional standards of due care. Also referred to as constructive fraud
Gross Negligence
Definition: An absence of reasonable or due care in the conduct of an engagement. Due care is evaluated in terms of what other professional accountants would have done under similar circumstances.
Ordinary Negligence
Definition: A contract or specific agreement exists between two parties. Absent a contractual or fiduciary relationship, the accountant does not owe a duty of care to an injured party.
Privity
Definition: A wrongful act, other than breach of contract, for which civil action may be taken.
Tort
Common Law - Liability to clients
Breach of contract, Negligence, Gross negligence, fraud
Common Law - 3rd parties
Negligence, Gross negligence, fraud
Federal Statutory Law - Civil Liability
Negligence, Gross negligence, fraud
Federal Statutory Law - Criminal Liability
Willful violation of federal statutes
Client must establish for negligence:
- A duty was owed to the client. 2. Failure to act in accordance with that duty. 3. A causal connection between the auditor’s negligence and the client’s damage.4. Actual loss or damage to the client.
Auditor’s Available Defenses for negligence:
- No duty was owed to the client. 2. Contributory negligence. 3. The auditor’s work was performed in accordance with professional standards. 4. The client suffered no loss. 5. Any loss was caused by other events (i.e. auditor did not cause loss) 6. The claim is invalid because the statute of limitations has expired.
Common Law Liability for Ordinary Negligence to Third Parties Approach: Auditor aware of identity, they are specifically identified, and auditor acted as though aware
Credit Alliance v. Arthur Andersen & Co.
- Near Privity
Common Law Liability for Ordinary Negligence to Third Parties Approach: Reasonably limited and identifiable group of users, even if persons were not specifically known to auditors at time audit was done
Restatement of Torts (Restatement Rule)
- Foreseen users
Common Law Liability for Ordinary Negligence to Third Parties Approach: Users the auditor should have reasonably been able to foresee as users of F/S have same rights as those privy to contract
Reasonably Forseeable User
Common Law Liability for Ordinary Negligence to Third Parties Approach: Authoritative set of legal principles
Restatement of Torts (Restatement Rule)
- Foreseen users
COMMON LAW—THIRD PARTIES: Third Party Must Prove for Negligence
- The auditor had a duty to the plaintiff to exercise due care. 2. The auditor breached that duty and was negligent in not following the professional standards. 3. The auditor’s breach of due care was the direct cause of the 3rd party’s injury. 4. The 3rd party suffered an actual loss as a result.
COMMON LAW—THIRD PARTIES: Auditor’s Defense for Negligence
- No duty was owed to the 3rd party (level of duty required depends on the case law followed by the courts). 2. The 3rd party was negligent. 3. The auditor’s work was performed in accordance with professional standards (i.e. the auditor exercised due care). 4. The 3rd party suffered no loss. 5. Any loss was caused by other events. 6. The claim is invalid because the statute of limitations has expired.
Third Party Must Prove - Fraud
- A false representation by the CPA. 2. Knowledge or belief by the CPA that the representation was false. 3. The CPA intended to induce the 3rd party to rely on the false representation. 4. The 3rd party relied on the false representation. 5. The 3rd party suffered damages.
Statutory Liability - Three major statutes that provide sources of liability for auditors:
- The Securities Act of 1933 2. The Securities Exchange Act of 1934 3. FCPA (records & IC) & Sarbanes-Oxley Act of 2002
Generally regulates the disclosure of information in a registration statement for a new public offering of securities.
Securities Act of 1933
Section 11 imposes a liability on issuers and others, including auditors, for losses suffered by 3rd parties when false or misleading information is included in a registration statement.
Securities Act of 1933
What was missing from the Securities Act of 1933 that 3rd-parties had to prove?
Don’t have to show auditor did anything wrong in order to sue (or auditor misconduct). Auditor guilty until proven innocent.
Concerned primarily with ongoing reporting by companies whose securities are listed and traded on a stock exchange.
Securities Exchange Act of 1934
Section 18 imposes liability on any person who makes a material false or misleading statement in documents filed with the SEC. Section 10(b) and Rule 10b-5 are the greatest source of liability for auditors under this act.
Securities Exchange Act of 1934
Securities Exchange Act of 1934 - 3rd party must prove:
- Amaterial, factual misrepresentation or omission. 2. Reliance on the financial statements. 3. Damages suffered as a result of reliance on the financial statements. 4. Scienter (the act was committed knowingly).
Provides for proportionate liability for defendants based on percentage of responsibility and a specific statement of fraud at the beginning of the case
Private Securities Litigation Reform Act of 1995
Prevents plaintiffs from seeking to evade the protections that Federal law provides against abusive litigation by filing suit in State, rather than Federal Court
Securities Litigation Uniform Standards Act of 1998
Expands federal jurisdiction to include multistate class actions where there is more than $5 million in dispute. Expected to help in more consistent dismissal of dubious claims.
Class Action Fairness Act of 2005
Sarbanes-Oxley Act of 2002 - 4 key impacts
- Creation of PCAOB 2. Stricter independence rules 3. Audits of internal controls 4. Increased reporting responsibilities. Most sweeping securities law since 1934
Liability Under Sarbanes-Oxley: Penalty for Failure to maintain workpapers for at least five years
Felony w/penalty up to 10 years
Liability Under Sarbanes-Oxley: Penalty for Document destruction
Felony w/ penalty of up to 20 years
Liability Under Sarbanes-Oxley: Penalty for Securities fraud
Criminal penalties increased to 25 years
Liability Under Sarbanes-Oxley: Penalty for Fraud discovery
Statute of limitations extended to 2 years from discovery and 5 years from act
Anchoring and Adjustment - When auditors exhibit this:
Fraud Frequencies, PriorYear Working papers, unaudited values - Affected tax asset judgments also
Anchoring and Adjustment - Situations when auditors do not exhibit this:
Task specific experience seems to mitigate this - Simply imagining alternatives
Definition: the phenomenon of outcome knowledge altering the evaluations of an ex-ante judgment of the occurrence of an event
Hindsight bias
_____ ______ are related and affect quality of ex-ante judgments that turned out to be wrong
Outcome Effects
influence more by most thing you see (pain study) - IC, Accounting Issues, GC, Performance Evals
Recency Bias (Order Effects) - significant experience and motivational factors seem to decrease this.
Bias that occurs with multiple clients:
Contrast Effects
Definition: People tend to direct their information search towards evidence that confirms their beliefs, thereby following a positive test strategy. Motivation plays a key role
Confirmatory Strategies
Strategy used when standards are subjective = Bias evidence collection, Depth of information processing, Information combination supporting conclusion, The goal is only accepted if it can be justified while maintaining the “illusion of objectivity”
Motivated Reasoning - Directional Goals
Judgement Bias: Very important that we have objectivity even at the lower level
Source Reliability
Models of how people actually make decisions
descriptive models
Models how people should make decisions
normative models
Problem with Rational Decision Making:
Weight the criteria - Problems if try to apply broadly among different people & – they can change depending on the others (weighting is VERY subjective)
(Potential) Problems with Rational Decision Making:
- Human Cognitive Limits (Bounded Rationality) 2. Criteria/goals are malleable, hard to compare, 3. Uncertainty and risk 4. Emotions or Affect 5. Framing 6. Subjective Utility is difficult to quantify
Decision Strategies/ JudgmentsUnder Uncertainty: A relatively simple strategy or rule of thumb that may or may not produce the correct answer.
Heuristic
Decision Strategies/ JudgmentsUnder Uncertainty: An often complex rule or procedure that always produces the correct answer if followed correctly.
Algorithm
Heuristic: We judge the likelihood (probability) of an event by deciding how representative that event is of a larger population of events from which it was drawn
The Representativeness Heuristic
Definition: The frequency of an event in the general population.
Base Rate
Info we tend to ignore
Sample Size and Base Rate
Heuristic: When people make estimates of likelihood, their estimates are influenced by the ease with which relevant examples come to mind.
The Availability Heuristic
Overconfidence:
- People (novices & experts) are in general, much more confident about their decisions than is reasonable given the environment in which they are making their decisions. - Potential to close off the search for answers before all available evidence can be collected because of overconfidence. - Plausibility vs. Sufficiency
Plausibility vs. Sufficiency
Auditor have tendency to accept 1st plausible and don’t consider enough the sufficiency of the answer (overreliance on mngmnt explanation)
Forms of Overconfidence: Being too certain that you know the truth.
Over-precision
Forms of Overconfidence: Thinking you are better than you really are.
Overestimation
Forms of Overconfidence: Falsely thinking that you are better than others.
Overplacement
Some consequences of overconfidence:
Stock market bubbles, Strikes, Unnecessary lawsuits, High rates of entrepreneurial failure, Failure of mergers and acquisitions
Bias: Changing hypotheses requires greater cognitive effort than maintaining the same hypothesis. Harder to deal with negative (disconfirming) information than positive information. Self-fulfilling prophecy
Confirmation Bias
How a problem is worded (or framed), either in terms of cost or value effects how people make decisions.
Tha Framing Effect
Example: A manager’s mood may influence his or her decision-making. He or she may be more likely to give positive performance evaluations when in a good mood.
Affect Heuristic
______ ______ are irrelevant to current decisions- instead, only incremental costs should influence future decisions.
Sunk Cost (Effect)
The SEC’s rules are predicated on three basic principles of auditor objectivity and independence:
- An auditor should not audit his or her own work. 2. An auditor should not function in the role of management. 3. An auditor should not serve in an advocacy role for his or her client.
SEC (2000) and SOX (2002) ban 9 types of non-audit services:
- bookkeeping 2. financial IS design and implementation 3. appraisal or valuation services 4. actuarial services 5. internal audit outsourcing services 6. management functions or human resources 7. investment adviser banking services 8. legal services and expert services9. any other service deemed unacceptable by the PCAOB
the risk that the auditor may unknowingly fail to appropriately modify his or her opinion on financial statements that are materially misstated (AU 312.02).
Audit Risk
the risk that an auditor incurs loss or injury to his or her professional practice from litigation, adverse publicity, or other events arising in connection with financial statements audited and reported on (AU 312.02, fn 2).
Auditor Business Risk (Engagement Risk)
the risk that an audit client’s economic condition will deteriorate in the future.
Client Business Risk
2 risks of material misstatment
Control risk and inherent risk
The risk that a misstatement that could occur in an account balance or class of transactions and that could be material, individually or when aggregated with misstatements in other balances or classes, will not be prevented or detected and corrected on a timely basis by the accounting and internal control systems. (measurable) Detecting or preventing problems
Control Risk
The risk that an auditor’s substantive procedures will not detect a misstatement that exists in an account balance or class of transactions that could be material, individually or when aggregated with misstatements in other balances or classes. Sampling vs. Nonsampling Risk – Risk due to testing
Detection Risk
An item is considered _____ if knowledge of the misstatement would affect the decision of a reasonable user.
Material
Detection Risk is _______ related to the amount of evidence required
Inversely
Detection Risk is _______ related to the amount of evidence required
Inversely
Audit risk assessment dangers…
Auditors rely on controls and assess inherent risk below the maximum on most audits
Preliminary Materiality:
Allocated to audit segments – Usually to balance sheet items & Tolerable misstatement
Preliminary Materiality:
Allocated to audit segments – Usually to balance sheet items & Tolerable misstatement
Material weakness - Magnitude? Likelihood?
Magnitude: Material Likelihood: Reasonably Possible or Probable
Definition: the purposeful intervention in the external financial reporting process, with the intent of obtaining some private gain
Earnings Management
Category of EM: opportunistic accounting estimates
Accounting Manipulation
Category of EM: The use of actual business transactions to manipulate earnings.
Real Activities
Category of EM: The opportunistic classification of items within the income statement, statement of cash flows, and balance sheet.
Classification Shifting
What is the following factor’s relationship to sample size, Direct or indirect? Tolerable Misstatement
Inverse, as it decreases, sample size increases
What is the following factor’s relationship to sample size, Direct or indirect? Expected Misstatement
Direct, as it decreases, sample size decreases and vice versa
