Chapter 5- Auditing Exam 2

. Describe and apply the elements of (1) Audit Risk

Audit risk (AR) o Risk the auditor expresses an inappropriate opinion when the financial statements are materially misstated o Is a function of (1) risk of material misstatement (RMM) and (2) detection risk (DR) o AR = RMM * DR o AR = (IR * CR) * DR Detection risk (DR) the only element of AR under the auditor's control o The risk that the audit procedures to reduce audit risk to an acceptably low level will not detect a misstatement that exists and that could be material, either individually or when aggregated with other misstatements. o The auditor obtains sufficient appropriate audit evidence to obtain reasonable assurance about whether material misstatements exist. o The auditor should design and perform audit procedures that are appropriate in the circumstances for the purpose of obtaining sufficient appropriate audit evidence. o Controlling DR: Function of the effectiveness of an audit Assisted by • Adequate planning • Proper assignment of personnel to the engagement team • The application of professional skepticism • Supervision and review of the audit work performed

Describe and apply the elements of (2) the Risk of Material Misstatement, (IR, CR, & DR)

o Risk that the FSs are materially misstated prior to the audit o Exists at two levels Financial statement level Assertion level o Inherent risk (IR) - the susceptibility of an assertion about (1) class of transaction, (2) account balance, or (3) disclosure to a misstatement that could be material...before consideration of any related controls (e.g. clerk records check paid for wrong amount) o Control risk (CR) - the risk that a misstatement that could be material...will not be (1) prevented, or (2) detected and (3) corrected, on a timely basis by the entity's internal control (e.g. bank reconciliation fails to detect wrong amount)

. List the 3 categories of of financial statement assertions.

• Assertions about classes of transactions • Assertions about account balances at the period-end • Assertions about presentation and disclosure

List the two primary (and several secondary) functions of audit documentation.

•Primary functions o Evidence of the auditor's achievement of the overall audit objectives o Evidence that the audit was planned and performed in accordance with GAAS •Secondary functions o Assisting the engagement team to plan and perform the audit o Assisting the review of a predecessor auditor's work o Enabling the team to demonstrate accountability for its work o Assisting supervisory members to direct and supervise and review o Enabling QC reviews and inspections o Enabling the conduct of external inspections or peer reviews

Describe the relationships among (1) reasonable assurance, (2) detection risk, (3) financial statement assertions, (4) audit evidence, and (5) audit procedures.

• Audit evidence is gathered by the auditors to reduce audit risk - the risk that the auditors may fail to modify their opinion on financial statements that are materially misstated. • Audit evidence is gathered by the auditors to assess the risk of material misstatement and to restrict detection risk • Auditors perform audit procedures to obtain audit evidence that will allow them to draw reasonable conclusions as to whether the client's financial statements follow GAAP • An audit provides reasonable assurance to users of the financial statements with a clean opinion by the auditor • Since financial statements consist of a series of assertions by management, the auditors should obtain sufficient and appropriate evidence about each significant financial statement assertion

List and describe 6 major types of financial statement assertions. (There are actually 13 types across 3 categories. See item 5 above. The 13 can be grouped into 6 major types.)

• Existence and occurrence - Assets, liabilities, and equity interests exist and recorded transactions and events have occurred • Rights and obligations - the company holds rights to the assets and liabilities are the obligations of the company • Completeness - all assets, liabilities, equity interests, and transactions that should have been recorded have been recorded • Cutoff - transactions and events have been recorded in the correct accounting period • Valuation, allocation, and accuracy - all transactions, assets, liabilities, and equity interests are included in the financial statements at proper amounts • Presentation and disclosure - accounts are described and classified in accordance with GAAP and financial statement disclosures are complete, appropriate, and clearly expressed

Describe 3 basic approaches to auditing estimates, including fair values.

• Review and test management's process for developing the estimate, which often involves evaluating the reasonableness of the steps performed by management • Independently develop an estimate of the amount to compare to management's estimate • Review subsequent events or transactions bearing on the estimate, such as actual payments of an estimated amount made subsequent to year-end ***In auditing their clients' fair values, auditors should keep in mind that the goal is to (1) achieve a fair value that is the price that would be received to sell an asset, or the amount that must be paid to transfer a liability in an orderly transaction between market participants at the measurement date and to (2) determine that valuation techniques are consistently applied, or, if revisions are needed, they are accounted for as a change in accounting estimate.

Contrast routine transactions and nonroutine transactions (especially estimation transactions) and their relationship to audit risk

• Risk is lower for routine transactions and higher for nonroutine transactions and matters that require significant judgement (estimation transactions) • Routine transactions o Subject to systematic processing (noncomplex) [e.g retail sales or payroll (excluding bonuses, stock compensation, etc.)] • Nonroutine transactions (and estimation transactions) o Arise from matters such as the following: Related party transactions Greater management intervention to specify the accounting treatment Greater manual intervention for data collection and processing Complex calculations or accounting principles The nature of nonroutine transactions • Difficult for the entity to implement effective controls o Estimation transactions Matters that require significant judgement (e.g. accounting estimates) Arise from matters such as the following: • Accounting principles for accounting estimates or revenue recognition may be subject to differing interpretation • Required judgement may be subjective or complex or it may require assumptions about the effects of future events (for example, judgement about fair value)

List 7 types of audit evidence

•Accounting information system •Documentary evidence •Third-party representations •Physical evidence •Computations •Data interrelationships •Client representations

Distinguish between conditions that make audit evidence more or less reliable.

•Audit evidence is ordinarily more reliable when it is o Obtained from knowledgeable independent sources outside the company rather than nonindependent sources o Generated internally through a system of effective controls rather than ineffective controls o Obtained directly by the auditor rather than indirectly or by inference o Documentary in form rather than oral o Provided by original documents rather than copies

List, describe, and apply three basic types of audit documentation: (1) current files, (2) permanent files, and (3) administrative files.

•Current files o Current year working papers o Index and cross-referencing •Permanent files o Items of continuing audit interest o Typical items include Article of incorporation Engagement letters Intellectual property (copyrights, patent, etc.) Deeds and leases Insurance policies Stock option policies Lists of advisors (lawyers, bankers, investment analysts, etc.) Guarantees Past recommendations of the audit firm •Administrative files o Items that help auditors to plan, supervise, control, and coordinate the audit o Items could include Audit plans Internal control questionnaires and flowcharts engagement letters time budgets

List and describe the 2 levels at which financial statement risk exists.

•Firm level o Comes from management's incompetence or corruptness (lack of integrity) o Can be addressed through Emphasizing the need for more skepticism by the audit team Assigning more experienced staff or those with specialized skills or using specialists Providing more supervision Incorporating more unpredictability •Assertion level o There is inherent risk with different assertions. Example there is more inherent risk valuing a mortgage backed security than there is for valuing cash o Some can be addressed through more internal controls

Contrast the NTE of transactions.

•Nature (N) o obtain more reliable evidence o Often externally generated evidence •Timing (T) o Wait until year-end to obtain evidence form entire set of transactions as contrasted to performing interim testing, say two months prior to year-end and simply updating those procedures •Extent (E) o Holding other factors such as the nature and timing of procedures constant : The greater the risk of material misstatement, the greater the needed extent of substantive procedures The main way to increase the extent of audit procedures is to examine more items Sample sizes should reduce detection risk so as to restrict audit risk to a low level

List, describe, and apply 2 characteristics of appropriate audit evidence (relevance and reliability).

•Relevance o Relates to the assertion being addressed. For example, confirming a client's accounts receivable with customers may provide evidence on the existence of the receivables, but it provides very limited information relating to whether the client has completely recorded all receivable accounts •Reliability o Is dependent on the circumstances in which it is obtained o See below question for more on reliability

List and describe 3 purposes of audit procedures.

•Risk assessment procedures o To obtain an understanding of the client and its environment, including its internal control, to assess the risks of material misstatement •Further audit procedures o Test of controls When appropriate, to test the operating effectiveness of controls in preventing material misstatements o Substantive procedures To detect material misstatements at relevant assertion level. Substantive procedures include (a) analytical procedures, (b) tests of details of account balances, transactions, and disclosures

List, describe, and contrast 2 characteristics of audit evidence (sufficient and appropriate.) Describe the relationship between sufficiency and appropriateness of audit evidence.

•Sufficiency o The measure of the quantity of audit evidence. Affected by (1) the auditor's assessment of RMM & (2) the quality of audit evidence •Appropriateness o The measure of the quality of audit evidence o Relevance & Connects the purpose of an audit procedure and the assertion under consideration o Reliability o In providing support for the conclusions on which the auditor's opinion is based •Relationship between them o The higher the quality of audit evidence, the less may be required o Obtaining more audit evidence, however, may not compensate for its poor quality

Apply analytical procedures to financial statement information.

•Timing of analytical procedures o Risk assessment (sometimes referred to as planning analytical procedures o Substantive procedures o Final review •Steps involved o Develop expectation of account (or ratio) balance o Determine amount of difference that can be accepted without investigation o Compare the company's account (ratio) with the expectation o Investigate and evaluate significant differences •Developing an expectation o Prior period information o Anticipation results o Relationships among elements of financial information within a period o Industry information o Relationships between financial information and relevant nonfinancial data •Types of expectations o Trend analysis - analyze changes in accounts or comparisons of account balances to nonfinancial data Liquidity (e.g. current ratio) Leverage (e.g. debt to equity) Profitability (e.g. gross profit percentage) Activity (e.g. inventory turnover)