Auditing Exam #1

List some key elements that would be included in any working paper document.

-client name -period under audit -title describing contents of the working paper -File reference where the working paper fits in the audit file -Initials identifying the preparer -Initials identifying the reviewer -Cross referencing between working papers and evidence summarized elsewhere Permanent file- information and documentation that that applies to multiple audits. Current file- contains client information that is relevant for the duration of one audit.

Explain how setting a lower materiality level affects the number of items that are material and affects the decision about the nature, extent, and timing of the audit procedures?

A lower materiality level means a more extensive auditing procedures, requiring a too look for a more precise conclusion for their opinion. This would require more time for the auditor to conduct the audit.

What is a time series analysis? How could it be useful to an auditor?

An analysis of the relationship between variables over a period of time. Time-series analysis is useful in assessing how an economic or other variable changes over time. It can be useful to auditors when searching for variations in trends; such as business cycles and seasonal variations.

In context of fraud risk assessment, what is the purpose of the brainstorming session?

Auditors are encouraged to share thoughts and ideas about how fraud can be conducted and concealed.

Explain the approach adopted by auditors of identifying accounts and related assertions at risk of material misstatement. How does this help reduce audit risk to an acceptably low level?

Auditors must have an understanding of the business and the industry in which they operate. By understanding the business and the industry the auditor can identify accounts that would be a higher risk of material misstatement. If a business is in retail, inventory may a RMM.

How does the auditor's assessment of overall or planning materiality affect audit planning? What does an auditor consider when making the preliminary assessment of planning materiality?

Based on the risk assessment, an auditor will design the audit to most effectively and efficiently detect a material misstatement. The auditor uses professional judgment and keeps in mind the users of the financial statements.

Why are there procedures governing the client acceptance and continuance decision? Explain why auditors do not accept every client.

Because being with a "bad client" can damage the firm's reputation and lose public trust. Additionally auditors must be able comply with principles of professional ethics, such as integrity, objectivity, independence, professional competence, and due care. Also, sometimes an auditor might not have the necessary resources to conduct the audit.

Why is it important to maintain professional skepticism when gaining an understanding of related party transactions?

Because they can have a direct or indirect effect on the financial statements. Discussion on how related parties could be involved with fraud should be discussed. Fraud may be more easily committed among related parties. EX. Transactions between the client and the related parties could be arranged to conceal the misappropriation of assets. Business loans at years end could skew the financial statements. Related parties can evolve at anytime during the year.

Explain, using examples, how could you use analytical procedures in assessing risk of material misstatements of sales revenue.

By making comparisons auditors can see differences from prior years. If a new location is opened, a higher sales revenue would be expected by a predictable amount. Auditors are expected to compare expected results with actual results. Using trend analysis, auditors select a base year and restates all subsequent balances compared to the base year. Concerning sales, the auditor would have to consider economic factors, among other factors.

The quantitative materiality of an item is assessed relative to a particular base number. What are some of the choices for this base, and what factors guide the auditor in this choice?

Depending on the type of business, the auditor with develop planning materiality by calculating a percentage of an appropriate benchmark from an item on either the balance sheet or income statement. For example if a company is public profit before tax is an appropriate benchmark because it drives dividends. A not-for-profit, total assets or total revenues is an appropriate benchmark.

Assertions about account balances at the period-end

Existence- Assets, liabilities, equity interests exist Rights and obligations- The entity holds or controls the rights to assets, and liabilities are the obligation of the entity Completeness- All assets, liabilities, and equity interests that should have been recorded, were recorded Valuation and Allocation- Assets, liabilities, and equity interest are included in the financial statements for the appropriate amount, and any resulting valuation or allocation adjustments are appropriately recorded.

List and briefly explain the key factors the auditor considers during a risk assessment.

Gain an understanding of the entity- major customers, major suppliers, importer or exporter, changes in technology, warranties, discounts, client reputation, operations, selection and application of accounting principles, significant accounts and classes of transactions, relationship with employees, sources of financing, and ownership structure Gain an understanding of the industry and business environment- the client's position within its industry, the level of competition in the industry, and the client's size relative to its competitors. Other factors: Level of competition, reputation, legal, political, and regulatory environment, demand, and the economy. Compliance with laws and regulations. Obtain a general understanding of the laws and regulations that apply to this business.

What are some possible explanations of a change of gross-profit margin? How could the auditor investigate which of these explanations is the most likely cause of the change in the ratio?

Gross-profit margin measures whether a seller has sufficient markup on goods sold to pay for other expenses. A decline could mean that the seller is paying more for the goods or selling for less to the customer. An increase could mean the opposite. To investigate, an auditor can investigate previous years with net sales and COGS accounts.

Assertions about classes of transactions and events for the period under audit

Occurrence- that a transaction or event actually took place Completeness- all transactions or event that should have been recorded were Accuracy- Amounts and other data relating to recorded transactions and events have been recorded appropriately Cutoff- transactions and events have been recorded in the correct period Classification- Transactions and events have been recorded in the proper accounts

Explain the difference between planning materiality and performance materiality.

Planning materiality is the misstatement amount set at the planning stages of the audit based on the materiality on the financial statements as a whole and determines whether they are misleading to the user. Performance materiality is always less than planning materiality and is set for particular classes of transactions, account balances, or disclosures.

Compare and contrast the responsibilities of preparers and auditors regarding a financial statement audit.

Preparers of financial statements responsibilities: -Ensuring the information included in the financial statements in fairly presented and complies with the applicable financial reporting framework, which in the US is GAAP. -Designing, implementing, and maintaining control relevant to preparation and fair presentation of financial statements. -providing auditors with access to all records, documentation, personnel relevant to the preparation and fair presentation of financial statements, and any additional information the auditors may consider relevant to complete an audit. Auditors of financial statement responsibilities: -Conduct the audit with the appropriate auditing standards. Audit standards provide minimum requirements and guidance for performing an audit. -Planning and performing the audit with professional skepticism -Planning and performing the audit with professional judgment

When gaining an understanding of a client, an auditor will be interested in the entity's relationship with both the suppliers and customers. What aspects of the relationship will the auditor be interested in and how would they affect the assessment of the audit risk?

Satisfied customers who pay on time and if the entity has many customers this equates to a lower inherent risk, versus the opposite. Reputable suppliers that supply on a timely basis, have fewer returns, and the client pays them on time has a lower inherent risk, versus the opposite.

What is the purpose of the engagement letter? Are all engagement letters the same?

Sets out the terms of the audit engagement, to avoid any misunderstandings between the auditor and the client. No, not all engagement letters are the same but it follows same guidelines. It depends on the client, the type of business they operate(ex. for profit/not for profit), their industry. If it is a repeat client a new engagement letter is not necessary annually unless the terms of the engagement have changed.

Discuss the similarities and differences in the auditor's report for a public company client and private company client

Similarities: -Both require the term "independent" in the title -Both in the first paragraph explain that an audit was conducted and indentifies the financial statement and the date of the financial statements, but the public audit report states the auditor's opinion in the first paragraph. -Both a signature and date Differences: - A private company standard is called a unmodified report and a public company standard is called a unqualified report - Private companies address the owner or shareholders of the company and the board of directors, if that applies; Public companies address the shareholders and the board of directors -The first paragraph in a private report is the Introductory Paragraph and the public report is the Opinion Paragraph -Public report has a paragraph referencing Internal Control but a Private report the auditor states that it does not make an opinion on Internal Control. -Public report states in the Scope paragraph that it followed PCAOB standards and makes a brief statement about professional judgment that was used -Public report must disclose tenure an auditor has had with it's client

Explain how inspecting a client's intangible assets provides evidence about the completeness and existence assertions.

Since intangible assets are not physical in nature, auditors have to have a procedure in place to test the assertion that it exists and if it does exist it correctly recorded on the balance sheet. Good will for instance is an intangible asset that the auditor would have to determine whether it actually exists at all.

Why does an auditor need to understand a client's IT system? Explain how IT affects the financial statements.

So that the auditor can understand the associated risks and related controls. Risks include unauthorized access to computers, software, and data. IT is involved in initiating transactions, recording, process, corrections as needed, transfer to the general ledger, which all leads into the accuracy of the financial statements.

Discuss why an auditor consider the reliability of audit evidence.

The auditor is forming an opinion based on the evidence that they gather.

If auditors adopt a predominately substantive approach to the audit, do they have to consider and test the client's internal controls? Explain

The auditor will always have to consider the client's internal control, though if inherent risk is high and control risk is low, the auditor can rely more on the client's control. But, the auditor will still have to use substantive procedures to gather evidence regarding account balances. The auditor has to test the internal controls to verify it's effectiveness. If RMM is high the auditor will use year-end balances rather than the interim to determine materiality.

Are financial statements considered statements of fact? Discuss in the context of management assertions.

The financial statements cannot be considered fact because the amount of professional judgment which is required for management to determine certain values. An assertion is the statement or representation, explicit or implicit, made by management regarding the recognition, measurement, presentation, and disclosure of items included in the financial statement and notes. Assertions are divided up into three categories: classes of transactions and events, account balances at period-end, and presentation and disclosure.

Why would investors of a company demand an audit of the financial statements?

The investors want to know that the information that they are analyzing is presented in a fair manner in accordance with a financial reporting framework. They want to know that whether there are any material misstatement that would cause them to make an uneducated decision concerning their investment. They would need an audit to determine the status of the going concern of the company, whether they are in trouble with the government concerning taxes or regulations, with lendors, or the community at large.

An assurance engagement involves evaluation or measurement of subject matter against criteria. What criteria are used in a financial statement audit?

To provide financial statement users with an opinion by the auditor on whether the financial statements are fairly presented in accordance with an applicable financial reporting framework. No financial statements are free from error and are subject to professional judgement when it comes estimation of certain values, such as Allowance for Doubtful Accounts and the valuation of assets. The auditor must determine the Risk of Material Misstatement(RMM) and set a benchmark of materiality as to what an acceptable amount of material misstatements that would not inhibit informative decision making. The auditor must determine what the inherent risk, control risk, and detection risk. The auditors are responsible for: 1. Conducting the audit in accordance with the appropriate auditing standards. 2. Planning and performing the audit with professional standards. 3. Planning and performing the audit with professional judgement

Explain why the quality of audit evidence is determined by choice of audit procedure and the assertion most at risk of material misstatement.

Typically, higher quality evidence requires a lower quantity of evidence. An accounts receivable balance is a relevant assertion because an entity it affects the users of the financial statements in decision making. The entity has incentive to document the asset because it is a favorable assertion. The entity would most likely fulfill the completeness assertion when documenting the asset so the auditor would focus their procedure concerning the existence assertion.

Inspection of Documents and Assets: vouching and tracing

Vouching= A type of inspection in the auditor selects a transaction from the journal or the ledger and work backward to examine the underlying documentation. Vouching provides evidence for the occurrence and existence assertion Tracing= A type of inspection in the auditor selects source documents and works forward to the recording in the journal or general ledger.

Audit procedures: risk assessment procedure, test of controls, substantive procedure

risk assessment= method to understand the client and assess risk of material misstatement test of controls= test the operating effectiveness of the client's controls in preventing, detecting, or correcting material misstatement substantive= methods designed to detect material misstatement at the assertion level

Characteristics of Audit Evidence: sufficient, relevant, reliability

sufficient= quantity of audit evidence relevant= quality relevance reliability= relationship to the assertion being tested

Explain the relationship between risk assessment, risk response, and reporting phases of an audit.

These are the three general phases of an audit. Risk assessment gains understanding of the client, identifying factors that may impact the risk of material misstatement occurring in the financial statements, performing risk and materiality assessment, and developing an audit strategy. Risk response involves the performance of detailed tests of control and substantive, or detailed testing of transactions and accounts. The reporting phase involves the evaluation of the result of testing in light of the auditor's understanding of the client and forming an opinion on the fair presentation of the client's financial statements. Risk assessment identfies the areas of weakness, risk response tests those weakness, and the reporting phase formulates an opinion based on the results.

Explain the importance of the risk assessment phase of a financial audit.

To assess the risk that a material misstatement, caused by error or fraud, could occur in the client's financial statements. Material misstatements can mislead the public and financial institutions about their interactions with a company.

Consider the following statement: When inherent and control risk are assessed as high, the risk of material misstatement is assessed as high, and an auditor will set detection as low to reduce audit risk to an acceptably low level. Explain what it means to set the detection risk as low. What does this mean for the operation of the audit?

A lower detection risk allows an auditor to maintain a low audit risk. A low detection risk means the auditors increase the amount of detailed audit procedures used to test the year end balances and transactions from throughout the year.

Discuss some limitations of the financial statement audit:

1. Inherent limitations: are only able to offer 'reasonable assurance' over the truth and fairness of the financial statements rather than absolute assurance. 2. Use of Professional Judgment: Audit involves the use of judgment in the identification of audit risks, selection of appropriate auditing procedures and the interpretation of audit evidence. Inevitably the auditor may make misjudgments. 3. Use of Sampling: There is an inherent risk that the audit procedures may fail to detect a material misstatement in the financial statements due to the inability of auditors to perform detailed testing of the entire population of transactions and balances. 4. Management Representations: Auditors have to rely on the representations of management in order to assess the reasonableness of the matters concerning financial statements. Management can intentionally or unintentionally make misrepresentations. 5. Risk of Fraud: frauds are intended to be concealed by the perpetrators and therefore pose a very high risk of remaining undetected by the auditors 6. Time Constraints: Auditors face strict time constraints within which they have to provide their opinion on the financial statements. 7. Independence Threats: The perceived independence of an auditor is for instance impaired where a client accounts for a significant portion of the revenue of the audit firm 8. Scope: Non financial matters are generally not considered in the performance of the audit unless they have relevance to the financial statements.

List and describe the procedures for gathering audit evidence. At which stage is the each appropriate?

Inspection= examination of document and physical assets, which can be tested at risk assessment, test of controls, and substantive. Observation= an evidence gathering procedure that involves watching a process or procedure being carried out by client personnel or another party. Usually carried out during risk assessment and test of controls phase Inquiry= involves asking questions verbally or in written form of knowledgeable individuals, internal or external to the client. Test of controls or substantive procedure External confirmation= the auditor corresponds directly with a third party and the third party responds directly to the auditor on matters included in the confirmation. Bank confirmation, positive confirmation, and negative confirmation. Recalculation= checking mathematical accuracy of documents and records. Reperformance= independent execution of procedures or controls that were originally performed client personnel Analytical Procedure= evaluation of financial information by studying plausible relationship among financial and nonfinancial data. Risk assessment and substantive Scanning= auditors use the professional judgement to review accounting data to identify unusual or significant items that may be an material misstatement Audit Data Analytics= Using software to process massive amounts of data. risk assessment and risk response

What is the difference between liquidity and solvency? Why does the difference matter to the auditor?

Liquidity is an entity's ability to meet its needs for cash in the short term and solvency is an entity's ability to meet its long-term financial obligations. Cash is so vital, that it is closely monitored by the entity and external users. Cash flow statements has three categories: operating activities, investing activities, and financing activities. By understanding how their client measures and assesses its own performance and any restrictions implied by debt covenants, auditors gain a deeper understanding of accounts potentially at risk for material misstatement.

Are all audits the same? Why might an audit change from year to year?

No, each audit is unique. Every entity has different types of risk based on different business models and industries. An audit may change based on new accounting standards, new industry regulations, innovations in technology, the outcomes of previous audits may alter the succeeding audit years and how well the business is doing may raise professional skepticism.

Assertions about Presentation and Disclosure

Occurrence and rights and obligations- disclosed events, transactions, and other matters have occurred and pertain to the entity. Completeness- All presentations and disclosures that should have be in the financial statements has been included. Classification and understandability- Financial information is appropriately presented and described, and disclosures are clearly expressed Accuracy and Valuation- Financial and other information are disclosed fairly and in the appropriate amounts.