Audit Chapter 6 Notes
Substantive test portion
- Deals with financial statement account balances - Indirect and direct verification of income statement accounts
Management Responsibilities
- Financial Statements - Establishing effective internal control over financial reporting - Compliance with laws and regulations - Making all records and client personnel available to the auditors - Providing written representations at the end of the audit regarding its responsibilities and belief that the financial statements are free from material misstatement
Overall response to fraud risks
-Adjust professional skepticism and audit evidence -Adjust personnel assigned and supervision -Adjust scrutiny given to accounting principles -Predictability of auditing procedures
Audit procedures
-Analytical procedures -Inspection -Observation -Inquiry -Confirmation -Recalculation -Reperformance
Engagement letters-optional items
-Arrangements regarding: --conduct of the audit --use of specialists or internal auditors --obtaining information from predecessor auditors --fees and billing -Other services to be provided, such as examination of internal control over financial reporting -Limitation or other arrangements regarding liability of auditors or client -Conditions under which access to the auditors' working papers may be granted to others
Attractiveness of the industry
-Barriers to entry -Strength of competitors -Bargaining power of suppliers of raw materials and labor -Bargaining power of customers
Measuring and Reviewing Performance
-Budgets -Key performance indicators -Variance analysis -Segment performance reports -Balanced scorecard -External reviews of performance
Understanding the client's business, industry, regulatory, and other factors
-Competitive environment -Supplier and customer relationships -Technology developments -Major laws and regulations -Economic conditions -Attractiveness of the industry
Nature of the client
-Competitive position -Organizational structure -Accounting policies and procedures -Ownership -Capital structure -Product and service lines -Critical business processes -Internal control
Auditor Responsibilities
-Conducting an audit in accordance with GAAS or PCAOB standards -Obtaining an understanding of internal control to plan audit and to determine the nature, timing, and extent of procedures -Making communications required by auditing standards
Audit Planning—Overall
-Develop an overall audit strategy and an audit plan. -Plan use of client's staff. -Plan involvement of other CPAs. -Arrange for specialists. *On first year audits: -Communicate with predecessor auditors -Establish opening balances on the financial statements
Procedures to assess fraud risks
-Discussion among engagement team -Inquiries of management and other personnel -Planning analytical procedures -Considering fraud risk factors (incentives, opportunity, attitude or ability to rationalize)
Consideration of fraud throughout the audit
-Evaluating the results of audit tests -Discovery of fraud •Communication to appropriate level of management •If fraud involves senior management or material misstatement communicate to audit committee
Response to the possibility of management override
-Examining journal entries -Review accounting estimates for biases -Evaluating the business rationale for significant unusual transactions
Overall responses when assessed risks of material misstatement are high
-Heightened professional skepticism -Assigning more experienced staff -Assigning staff with specialized skills -Providing more supervision
Sources of Information
-Inquiries of management -Industry Accounting and Auditing Guides -Industry Risk Alerts -Trade journals and news stories -Government publications -Prior company annual reports and SEC filings -Prior tax returns -Electronic sources -Tour of plant and offices -Preliminary analytical procedures -The statement of cash flows
Perform risk assessment procedures, including
-Inquiries of management and other within the entity -Analytical procedures -Observation and inspection relating to client activities, operations, documents, reports and premises -Other procedures, such as inquiries of others outside the company and reviewing information from external sources such as analysts, banks, rating organizations, newspapers and journals
Engagement letters
-Name of the entity -Management responsibilities -Auditor responsibilties
Auditors' consideration of internal control is often organized around client's major transaction cycles (examples):
-Revenue (sales) and collections cycle -Acquisition and payments cycle -Conversion cycle -Payroll cycle -Investing cycle -Financing cycle
Further audit procedures should include
-Substantive procedures for all material relevant assertions -Tests of controls when the auditors' risk assessment includes an expectation that controls are operating effectively, or when substantive procedures alone are not sufficient
Auditor may follow the audit trail in either of two directions related to the direction of testing
-Test for existence or occurrence: vouching transactions from recorded amounts to source documents -Test for completeness: Tracing of transactions from source documents to recorded amounts
Types of further audit procedures
-Test of controls -Analytical procedures -Test of details of transactions and balances
Determining Materiality
-Use professional judgment and based on reasonable person -Considers both quantitative and qualitative factors -Materiality used in: --Planning the audit --At the overall financial statement level --Allocate to individual accounts -Evaluating audit findings
Need knowledge and understanding of how a client's internal control works:
-What controls exist -Who performs them -How various types of transactions are processed and recorded -What accounting records and supporting documentation exist
Inquiries about the substantial increase in revenue TWD recorded in the fourth quarter of 20X1 disclosed a new operating policy. TWD guaranteed to several municipalities that it would refund the federal and state funding paid to TWD if any municipality fails a federal or state site clean-up inspection in 20X2.
Increase risk of material misstatement
TWD's Board of Directors is controlled by Janice Mead, the majority stockholder, who also acts as the chief executive officer.
Increase risk of material misstatement
The accounting department has experienced a high rate of turnover of key personnel.
Increase risk of material misstatement
Materiality according to FASB
Information is material if omitting it or misstating it could influence decisions that users make on the basis of the financial information of a specific reporting entity
Systems portion
- Deals with client's internal control - Evidence of test of controls and assessing control risk
Alterations in audit procedures
-More reliable evidence -Shifting timing to year end -Increasing sample sizes
Audit Process Steps
1. Plan the audit 2. Obtain an understanding of the client and its environment, including internal control 3. Assess the risks of material misstatement and design further audit procedures 4. Perform further audit procedures 5. Complete the audit 6. Form an opinion and issue the audit report
Two types of fraud risk
1. fraudulent financial reporting (management fraud) 2. misappropriation of assets (defalcations)
Obtaining clients
1. submit a proposal 2. communicate with the predecessor auditor
Materiality according to PCAOB
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
Which of the following should not normally be included in the engagement letter for an audit?
A listing of the client's branch offices selected for testing.
Audit trail
A trail of evidence that links original recording of a transaction, journal entries, and ledger entries
In planning and performing an audit, auditors are concerned about risk factors for two distinct types of fraud: fraudulent financial reporting and misappropriation of assets. Which of the following is a risk factor for misappropriation of assets?
An unreliable accounting system.
In directional testing, tracing from source documents to journals most directly addresses this assertion.
Completeness
The client recorded year-end sales in the subsequent year.
Cutoff
Because municipalities have received increased federal and state funding for environmental purposes, TWD returned to profitability for the first year following three years with losses.
Decrease risk of material misstatement
TWD's bank has a loan officer who meets regularly with TWD's CEO and controller to monitor TWD's financial performance.
Decrease risk of material misstatement
The primary objective of tests of details of transactions performed as substantive procedures is to:
Detect material misstatements in the financial statements.
The risk that the auditors will conclude, based on substantive procedures, that a material misstatement does not exist in an account balance when, in fact, such misstatement does exist is referred to as
Detection risk
Consideration of fraud
Discussion of audit team, procedures used to identify fraud risks, fraud risks and responses, any other conditions that caused fraud-related procedures, and communications with management or audit committee
Risk assessment
Discussion of the audit team, elements of auditors' understanding, assessment of risk of material misstatement, and risks identified
The client recorded receivables that were fictitious.
Existence and occurrence
Which of the following best describes what is meant by the term "fraud risk factor"?
Factors often observed in circumstances where frauds have occurred.
Which of the following should the auditors obtain from the predecessor auditors before accepting an audit engagement?
Facts that might bear on the integrity of management.
During December 20X1, TWD signed a contract to lease disposal equipment from an entity owned by Janice Mead's parents. This related party transaction is not disclosed in TWD's notes to the 20X1 financial statements.
Increase risk of material misstatement
TWD has such a strong financial presence in its industry to allow it often to dictate the terms or conditions of transactions with its suppliers.
Increase risk of material misstatement
Which of the following elements underlies the application of generally accepted auditing standards, particularly the standards of fieldwork and reporting?
Materiality and audit risk.
The audit committee of a company must be made up of:
Members of the board of directors who are not officers or employees.
During December 20X1, TWD increased its casualty insurance coverage on several pieces of sophisticated machinery from historical cost to replacement cost.
No effect on risk of material misstatement
Procedure results
Overall responses, the nature, timing and extent of further audit procedures, the linkage of procedures with assessed risks, the results of audit procedures, conclusions reached about operating effectiveness of controls, significant risks identified, and circumstances in which substantive procedures alone will not provide sufficient evidence
The client failed to describe in the financial statements significant debt restrictions.
Presentation and disclosure
As one step in testing sales transactions, a CPA traces a random sample of sales journal entries to debits in the accounts receivable subsidiary ledger. This test provides evidence as to whether:
Recorded sales have been properly posted to customer accounts.
The assertion most directly related to the question of ownership of an asset.
Rights and obligations
Which portion of an audit is least likely to be completed before the balance sheet date?
Substantive procedures
Three conditions generally are present when fraud occurs. Select the one below that is not one of those conditions.
Supervisory position
Which of the following is most likely to be an overall response to fraud risks identified in an audit?
Use less predictable audit procedures.
The authenticity and accuracy of an account receivable may be tested by __________ with the debtor, or by vouching entries in the account to supporting documents.
confirmation
The term __________ refers to the process of determining that transactions are reflected in the proper accounting period.
cutoff
Audit risk at the account balance level consists of three components: (1) __________, (2) control risk and (3) detection risk.
inherent risk
The auditors must assess the risk of material misstatement of financial statements due to the two types of fraud, fraudulent financial reporting and __________.
misappropriation of assets
Assertions are __________ that are set forth in the financial statements.
representations of management
Performing certain audit procedures at an interim date, rather than at the balance sheet date, results in additional __________ that must be controlled by the auditors.
risk
Tests of balances and transactions designed to detect material misstatements are called __________.
substantive procedures (tests)
Audit procedures that are focused on the effectiveness of internal control are called __________.
test of controls
