Audit Chapter 7

Relevance and reliability both involve

audit procedures timing

Permanent files

auditor's files that contain data of a historical or continuing nature pertinent to the current audit such as copies of articles of incorporation, bylaws, bond indentures, and contracts

Schedule key words

client period description initials date index

Audit procedure is the __________ ____________ for the ___________ of a type of _________ ________________ that is to be __________. Audit procedures are the _______________ to be ________ in _______________ ___________.

detailed instruction collection audit evidence obtained instructions followed accumulating evidence

Audit procedure

detailed instruction for the collection of a type of audit evidence

Supporting schedules

detailed schedules prepared by the client or the auditor in support of specific amounts on the financial statements

Analytical procedures

evaluations of financial information through analysis of plausible relationships among financial and nonfinancial data

Audit report is: What else are included?

list of audit procedures 4 Ws

Audit program

list of audit procedures of an audit area or an entire audit; the audit program always includes audit procedures and may also include sample sizes, items to select, and timing of the tests

Observation

looking at a process or procedure being performed by others

For how long does the Sarbanes-Oxley Act require auditors of public companies to retain audit documentation?

period of not less than 7 years

Types of evidence key words

physical examination confirmation inspection analytical procedures inquiries of client recalculation re performance observation

Documentation Key Words

plan record audit report review sufficient appropriate evidence

2 primary reasons auditor can only be persuaded with _________ level of assurance 1. 2.

reasonable 1. cost 2. evidence is normally not sufficiently reliable

Audit documentation

record of the audit procedures performed, relevant audit evidence, and conclusions the auditor reached

appropriateness refers to (2)

relevance and reliability

Evidence key words

reliability independence Internal control direct knowledge qualifications objectivity timeliness

Sufficiency refers to (2)

sample size (quantity of evidence) items to select

Unusual fluctuations

significant unexpected differences indicated by analytical procedures between the current year's unaudited financial data and other data used in comparisons

Tick marks

symbols used on an audit schedule that provide additional information or details of audit procedures performed

Inspection

the auditor's examination of the client's documents and records to substantiate the information that is or should be included in the financial statements

Performance

the auditor's independent tests of client account procedures or controls that were originally done as part of the entity's accounting and internal control system

Physical examination

the auditor's inspection or count of a tangible asset

Confirmation

the auditor's receipt of a direct written or electronic response from a third party verifying the accuracy of information requested

Persuasiveness of evidence

the degree to which the auditor is convinced that the evidence supports the audit opinion; the two determinants of persuasiveness are the appropriateness and sufficiency of the evidence

Reliability of evidence

the extent to which evidence is believable or worthy of trust; evidence is reliable when it is obtained 1. From an independent provider 2. From a client with effective internal controls, 3. From the auditor's direct knowledge, 4. From qualified providers such as law firms and banks 5. From objective sources and 6. In a timely manner

Inquiry

the obtaining of written or oral information from the client in response to specific questions during the audit

Sufficiency of evidence

the quantity of evidence; proper sample size

Recalculation

the rechecking of a sample of the computations made by the client, including mathematical accuracy of individual transactions and amounts and the adding of journals and subsidiary records

Tracing

the use of documentation to determine if transactions or amounts are included in the accounting records

Vouching

the use of documentation to support recorded transactions or amounts

4 Ws (short)

which, what, which, when

Budgets

written records of the client's expectations of the period; a comparison of budgets with actual results may indicate whether or not misstatements are likely

Identify the most important reasons for performing analytical procedures

1 Understanding the client's business and industry 2. Assessment of the entity's ability to continue as a going concern 3. Indication of the presence of possible misstatements in the financial statements 4. Reduction of detailed audit tests

List the 8 types of audit evidence included in this chapter and give 2 examples of each.

1. Physical examination Count inventory in warehouse Examine fixed asset additions 2. Confirmation Confirm accounts receivable balances of a sample of client customers Confirm client's cash balance with bank 3. Inspection Examine copies of monthly bank statements Examine vendors' invoices supporting a sample of cash disbursement transactions throughout the year 4. Analytical procedures Evaluate reasonableness of receivables by calculating and comparing ratios Compare expenses as a percentage of net sales with prior year's percentages 5. Inquiries of the client Inquire of management whether there is obsolete inventory Inquire of management regarding the collectibility of large accounts receivable balances 6. Recalculation Recompute invoice total by multiplying item price times quantity sold Foot the sales journal for a one-month period and compare all totals to the general ledger 7. Reperformance Agree sales invoice price to approved price list Match quantity on purchase invoice to receiving report 8. Observation Observe client employees in the process of counting inventory Observe whether employees are restricted from access to the check signing machine

What are the characteristics of a confirmation? Distinguish between a confirmation and external documentation

1. Receipt directly by auditor 2. Written or electronic response 3. From independent third party 4. Requested by the auditor

4 Ws (full)

1. Which audit procedure to use 2. What sample size to select for given procedure 3. Which items to select from population 4. When to perform procedures

List the 4 major evidence decisions that must be made on every audit.

1. Which audit procedures to use. 2. What sample size to select for a given procedure. 3. Which items to select from the population. 4. When to perform the procedure.

2 determinants of persuasiveness

1. appropriateness 2. sufficient

Appropriateness of evidence

: a measure of the quality of evidence; appropriate evidence is relevant and reliable in meeting audit objectives for classes of transactions, account balances, and related disclosures

Describe what is meant by an audit procedure. Why is it important for audit procedures to be carefully worded?

An audit procedure is the detailed instruction for the collection of a type of audit evidence that is to be obtained. Because audit procedures are the instructions to be followed in accumulating evidence, they must be worded carefully to make sure the instructions are clear.

Describe what is meant by an audit program for accounts receivable. What 4 things should be include in an audit program?

An audit program for accounts receivable is a list of audit procedures that will be used to audit accounts receivable for a given client. The audit procedures, sample size, items to select, and timing should be included in the audit program

What is the primary purpose of analytical procedures performed during the completion phase of the audit?

Analytical procedures are required during two phases of the audit: (1) during the planning phase to assist the auditor in understanding the client's business and industry and to assist in determining the nature, extent, and timing of work to be performed, and (2) during the completion phase, as a final review for material misstatements or financial problems. Analytical procedures are also often done during the testing phase of the audit as part of the auditor's further audit procedures, but they are not required in this phase.

Distinguish between attention-directing analytical procedures and those intended to eliminate or reduce detailed substantive procedures.

Attention-directing analytical procedures occur when significant, unexpected differences are found between current year's unaudited financial data and other data used in comparisons. If an unusual difference is large, the auditor must determine the reason for it, and satisfy himself or herself that the cause is a valid economic event and not an error or misstatement due to fraud. If the analytical procedure indicates an increased risk of misstatement, the auditor should consider the likely causes and evaluate the effect on the nature and extent of substantive tests. Substantive analytical procedures are designed to reduce or eliminate detailed substantive tests. The effectiveness of an analytical procedure in providing substantive evidence depends on the predictability of the relationship and the reliability of underlying data used to support the analytical procedure calculations.

Who owns the audit files? Under what circumstances can they be used by other people?

Audit files are owned by the auditor. They can be used by the client if the auditor wants to release them after a careful consideration of whether there might be confidential information in them. The audit files can be subpoenaed by a court and thereby become the property of the court. They can be released to anotherCPA firm without the client's permission if they are being reviewed as a part of a voluntary peer review program under AICPA, state CPA society, or state Board of Accountancy authorization. The audit files can be sold or released to other users if the auditor obtains permission from the client.

Explain why it is important for audit documentation to include each of the following: identification of the name of the client, period covered, description of the contents, initials of the preparer and the reviewer, dates of the preparation and review, and an index code.

Audit schedules should include the following: Name of the client. Enables the auditor to identify the appropriate file to include the audit schedule in if it is removed from the files. Period covered. Enables the auditor to identify the appropriate year to which an audit schedule for a client belongs if it is removed from the files. Description of the contents. A list of the contents enables the reviewer to determine whether all important parts of the audit schedule have been included. The contents description is also used as a means of identifying audit files in the same manner that a table of contents is used. Initials of the preparer. Indicates who prepared the audit schedule in case there are questions by the reviewer or someone who wants information from the files at a later date. It also clearly identifies who is responsible for preparing the audit documentation if the audit must be defended. Date of preparation. Helps the reviewer to determine the sequence of the preparation of the audit schedules. It is also useful for the subsequent year in planning the sequence of preparing audit schedules. Indexing. Helps in organizing and filing audit schedules. Indexing also facilitates in searching between related portions of the audit documentation

Discuss the similarities and differences between evidence in a legal case and evidence in an audit of financial statements

In both a legal case and in an audit of financial statements, evidence is used by an unbiased person to draw conclusions. In addition, the consequences of an incorrect decision in both situations can be equally undesirable. For example, if a guilty person is set free, society may be in danger if the person repeats his or her illegal act. Similarly, if investors rely on materially misstated financial statements, they could lose significant amounts of money. Finally, the guilt of a defendant in a legal case must be proven beyond a reasonable doubt. This is similar to the concept of sufficient appropriate evidence in an audit situation. As with a judge or jury, an auditor cannot be completely convinced that his or her opinion is correct, but rather must obtain a high level of assurance. The nature of evidence in a legal case and in an audit of financial statements differs because a legal case relies heavily on testimony by witnesses and other parties involved. While inquiry is a form of evidence used by auditors, other more reliable types of evidence such as confirmation with third parties, physical examination, and inspection are also used extensively. A legal case also differs from an audit because of the nature of the conclusions made. In a legal case, a judge or jury decides the guilt or innocence of the defendant. In an audit, the auditor issues one of several audit opinions after evaluating the evidence.

Identify the 6 characteristics that determine the reliability of evidence. For each characteristic, provide one example of a type of evidence that is likely to be reliable.

Independence of provider: Confirmation of a bank balance Effectiveness of client's internal controls: Use of duplicate sales invoices for a large well-run company Auditor's direct knowledge: Physical examination of inventory by the auditor Qualifications of provider: Letter from an attorney dealing with the client's affairs Degree of objectivity: Count of securities on hand by auditor Timeliness: Observe inventory on the last day of the fiscal year

Distinguish between internal documentation and external documentation as audit evidence and give 3 examples of each.

Internal documentation is prepared and used within the client's organization without ever going to an outside party, such as a customer or vendor. Examples: check request form receiving report payroll time record adjusting journal entry External documentation either originated with an outside party or was an internal document that went to an outside party and is now either in the hands of the client or is readily accessible. Examples: vendor's invoice cancelled check cancelled note validated deposit slip

Describe the liquidity activity ratios and explain why these ratios are useful to auditors.

Liquidity activity ratios, such as accounts receivable turnover, days to collect receivables, inventory turnover, and days to sell inventory, provide information about how long it takes a company to convert less-liquid current assets into cash. Auditors often use trends in these ratios from period-to-period to assess collectibility of receivables or potential obsolescence of inventory.

Discuss strength and shortcomings in use of ratio and trend analysis.

Roger Morris performs ratio and trend analysis at the end of every audit. By that time, the audit procedures are completed. If the analysis was done at an interim date, the scope of the audit could be adjusted to compensate for the findings, especially when the results suggest a greater likelihood of material misstatements. Analytical procedures must be performed in the planning phase of the audit and near the completion of the audit. The use of ratio and trend analysis appears to give Roger Morris an insight into his client's business and affords him an opportunity to provide excellent business advice to his client. It also helps provide a richer context for Roger to really understand his client's business, which should help Roger in assessing the risk of material misstatements.

Explain why the auditor can be persuaded only with a reasonable level of assurance, rather than convinced, that the financial statements are correct.

The cost of accumulating evidence. It would be extremely costly for the auditor to gather enough evidence to be completely convinced. 2. Evidence is normally not sufficiently reliable to enable the auditor to be completely convinced. For example, confirmations from customers may come back with erroneous information, which is the fault of the customer rather than the client.

Define what is meant by a permanent file, and list several types of information typically included. Why does the auditor not include the contents of the permanent file with the current year's audit file

The permanent file contains data of an historical and continuing nature pertinent to the current audit. Examples of items included in the file are: 1. Articles of incorporation 2. Bylaws, bond indentures, and contracts 3. Analysis of accounts that have continuing importance to the auditor 4. Information related to the understanding of internal control: a. flowcharts b. internal control questionnaires 5. Results of previous years' analytical procedures, such as various ratios and percentages compiled by the auditors By separating this information from the current year's audit files, it becomes easily accessible for the following year's auditors to obtain permanent file data

Distinguish among the following types of current period supporting schedules and state the purpose of each: analysis, trial balance, and substantive analytical procedures

The purpose of an analysis is to show the activity in a general ledger account during the entire period under audit, tying together the beginning and ending balances. The trial balance includes the detailed makeup of an ending balance. It differs from an analysis in that it includes only those items comprising the end of the period balance. A substantive analytical procedure involves comparison of the expectation of the account balance developed by the auditor to the recorded amount that enables the auditor to evaluate whether a certain account balance appears to be misstated.

Explain the purposes and benefits of audit engagement management software.

The purposes of audit engagement management software are to convert traditional paper-based documentation into electronic files and to organize the audit documentation, and help manage the engagement. The benefits of engagement management software are as follows: The software facilitates tracking audit progress by indicating the performance and review status of each audit area. The auditor can more efficiently prepare a trial balance, lead schedules, supporting audit documentation, financial statements, and ratio analysis using the computer rather than by hand. The effects of adjusting journal entries are automatically carried through to the trial balance and financial statements, making lastminute adjustments easier to make. Tick marks and review notes can be entered directly into computerized files, and the audit progress can be easily monitored. Data can be imported and exported to other applications. For example, a client's general ledger can be downloaded and tax information can be downloaded into a commercial tax preparation package after the audit is completed.

Current files

all audit files applicable to the year under audit

Identify the 2 factors that determine the persuasiveness of evidence. How are these two factors related to audit procedures, sample size, items to select, and timing?

The two determinants of the persuasiveness of evidence are appropriateness and sufficiency. Appropriateness refers to the relevance and reliability of evidence, or the degree to which evidence can be considered believable or worthy of trust. Appropriateness relates to the audit procedures selected, including the timing of when those procedures are performed. Sufficiency refers to the quantity of evidence and it is related to sample size and items to select.

Define what is meant by a tick mark. What is its purpose?

Tick marks are symbols adjacent to information in audit schedules for the purpose of indicating the work performed by the auditor. An explanation of the tick mark must be included at the bottom of the audit schedule to indicate what was done and by whom.

Substantive analytical procedure

an analytical procedure in which the auditor develops an expectation of recorded amounts or ratios to provide evidence supporting an account balance

Lead schedule

an audit schedule that contains the detailed accounts from the general ledger making up a line item total in the working trial balance

List the purposes of audit documentation and explain why each purpose is important.

To provide a basis for planning the audit. The auditor may use reference information from the previous year in order to plan this year's audit, such as the evaluation of internal control, the time budget, etc. To provide a record of the evidence accumulated and the results of the tests. This is the primary means of documenting that an adequate audit was performed. To provide data for deciding the proper type of audit report. Data are used in determining the scope of the audit and the fairness with which the financial statements are stated. To provide a basis for review by supervisors and partners. These individuals use the audit documentation to evaluate whether sufficient appropriate evidence was accumulated to justify the audit report. Audit documentation is used for several purposes, both during the audit and after the audit is completed. One of the uses is the review by more experienced personnel. A second is for planning the subsequent year audit. A third is to demonstrate that the auditor has accumulated sufficient appropriate evidence if there is a need to defend the audit at a later date. For these uses, it is important that the audit documentation provide sufficient information so that the person reviewing an audit schedule knows the name of the client, contents of the audit schedule, period covered, who prepared the audit schedule, when it was prepared, and how it ties into the rest of the audit files with an index code.

Why is it essential that the auditor not leave questions or exceptions in the audit documentation without an adequate explanation?

Unanswered questions and exceptions may indicate the potential for significant errors or fraud in the financial statements. These should be investigated and resolved to make sure that financial statements are fairly presented. The audit files can also be subpoenaed by courts as legal evidence. Unanswered questions and exceptions may indicate lack of due care by the auditor.

External document

a document, such as a vendor's invoice, that has been used by an outside party to the transaction being documented and that the client now has or can easily obtain

Internal document

a document, such as an an employee time report, that is prepared and used within the client's organization

Working trial balance

a listing of the general ledger accounts and their year-end balances