chapter 8 audit

Key thing about materiality

**the user - influence or change a reasonable user's decision

The preliminary judgement about materiality for FS which is step __ is the ___ ___ by which the auditors believes the statements could be misstated and still not affect ____________ ** most important decision auditor makes

1, maximum amount, the decisions of reasonable users

Why is the concept of materiality important (2)

1,audit procedures (materiality decrease, evidence incr) 2.threshold for concluding on misstatements in FS

What are the 5 key elements of understanding clients business and industry

1. Industry and external environment 2. Business operations and processes 3.Management and governance 4.objectives and strategies

Initial audit planning involves four things, all of which should be done early in the audit

1. The auditor decides whether to accept a new client or continue serving an existing one. 2. The auditor identifies why the client wants or needs an audit. This information is likely to affect the remaining parts of the planning process. 3. obtains an understanding with the client about the terms of the engagement. 4. The auditor develops the overall strategy for the audit, including engagement staffing and any required audit specialists.

Auditor's responsibilities when it comes to related parties:

1. The disclosure requirements: nature of the relationship, description of transactions (with $ amounts), amounts due and to related parties, 2. Include in the permanent files 3.Make sure the team knows who the related parties are - discover undisclosed transactions 4. Asks management about transactions with these related parties - type and purpose of transaction - Inquire management or those charged with governance - perform procedures to obtain understanding of controls management has established to identify, authorize, approve related party transactions 6.Auditors may also learn about related parties by reviewing SEC filings and examining stockholders' listings to identify principal stockholders.

When is materiality determined in an audit

1. When designing the audit procedures (Determination of nature, timing and extent of audit procedures - Materiality- aar decreases, evidence required increases) 2. When evaluating the results of audit evidence - If material - correct items, immaterial - show client but no change needed

What are some reasons why the preliminary judgment may be reevaluated

1. after current financial statements are available. 2. client circumstances may have changed due to qualitative events such as the issuance of debt, which created a new class of financial statement users.

Most auditors assess risk of material misstatement as high for related parties and related party transactions, why? (3)

1. because of the accounting disclosure requirements, 2. the lack of independence between the parties involved in the transactions, and the 3. opportunities they may provide to engage in fraudulent financial reporting.

Auditors are required to perform preliminary analytical procedures as part of risk assessment procedures in order to? (2)

1. better understand the client's business and industry 2.assess client business risk.

The 4 key parts of audit planning

1. client acceptance & planning 2.understand clients business and industry 3. perform preliminary analytical procedures 4.Set preliminary judgement of materiality and performance materiality

In the planning phase analytical procedures are done for what?

1. to identify risks, unusual transactions and what the auditor should focus on 2. Be able to design analytical procedures to detect error equal or greater to PM

What should the auditor look for in management and governance:

1.How often does the board meet 2. Belief in code of conduct 3. Key officers - relationship with board, look for related parties, qualifications 4. How is the organization managed, management style (rule with intimidation)

5 steps of materiality:

1.Set materiality for the FS as a whole 2.Determine performance materiality 3.Estimate total misstatement ins engagement 4.Estimate the combine misstatement 5. Compare combined estimate with preliminary or revise judgement about materiality

Auditors follow five closely related steps in applying materiality, as shown in Figure 8-5.

1.The auditor first determines materiality for the financial statements as a whole. 2. Second, the auditor determines performance materiality, which is materiality for segments of the audit (classes of transactions, account balances, and related disclosures) as shown in the first bracket of the figure. These two steps, which are part of planning, are our primary focus for the discussion of materiality in this chapter. 3. Step 3 occurs throughout the engagement, when auditors estimate the amount of misstatements in each segment as they evaluate audit evidence. Near the end of the audit, during the engagement completion phase, auditors proceed through the final two steps. 4. Estimate the combine misstatement 5. Compare combined estimate with preliminary or revise judgement about materiality

2 key points auditor's report states about materiality

1.obtain reasonable assurance 2. Free from material misstatement

What should the auditor do in relation to corporate minutes

1.read the minutes to obtain authorizations and other information that is relevant to performing the audit. 2. Include This information in the audit files with significant portions highlighted. 3. Before the audit is completed, the auditor must follow up on this information to be sure that management has complied with actions taken by the stockholders and the board of directors.

Similar prior periods __ or __ years

2 or 3 years

Business operations and processes refers to ________, sources of revenue, key customers, related parties, suppliers (where they are located), operations (are they global, what is their reach to identify risk), ____ reach

How the company makes their money, geographical

Measurement and performance refers to looking at ___ understanding ____ plan to assess risk, compensation Incentives, Competitor analysis look for ____, operating statistics - should be in line with what is going on in the business

KPIs, compensation, pressure

Non financial data includes ___ data such as sales per employee

Operational data

Auditor determined data includes

Our expectation / expected outcome - ex: estimated sales commission

The 4th part of audit planning includes

Set preliminary judgement of materiality and performance materiality

Purpose of analytical procedures Purpose

To be able to design audit procedures to detect error equal or greater than performance materiality

How can the auditor get an idea of clients business operations and processes

Tour their operations

Common examples of __ ____ include sales or purchase transactions between a parent company and its subsidiary, exchanges of equipment between two companies owned by the same person, and loans to officers.

Transactions of related parties

How the does the auditor understand the client;s business and industry, what do they do with this information

Use the 5 elements to understand the client, and assess risk of material misstatement (remember inherent risk)

Auditing standards require the auditor to document in the ____ the preliminary judgment about materiality and the___ used to determine it.

audit files, basis

Purpose of __ ___obtain understanding of client, ensure sufficient appropriate evidence is obtained, organization of the audit, minimize audit costs

audit planning

Analytical procedures Impact nature, timing and extent of _ __

audit procedures

Determining performance materiality (step 2) is necessary because?

auditors accumulate evidence by segments rather than for the financial statements as a whole, and the level of performance materiality helps them decide the appropriate audit evidence to accumulate.

Because materiality is relative, it is necessary to have ____ for establishing whether misstatements are material.

bench mark

Be able to explain how preliminary judgment about materiality is determined: 1.We start out with preliminary materiality - get a ____ - what is important to the users (revenue, net income etc) 2. ____ * by percentage {firm will give you this} (first quantitative measure) 3. adjust for ___factors for the FS as a whole 4. This gives you your __ ___

benchmark, benchmark, qualitative, preliminary materiality

Because auditors are responsible for determining whether financial statements are materially misstated, they must, upon discovering a material misstatement, what must the auditor do?

bring it to the client's attention so that a correction can be made.

What is the first step in planning and designing the audit is __ __ we must note that this is when collection of __ begins

client acceptance, audit evidence

When the business objective of client is not attained

client business risk

The 2nd part of audit planning includes the understanding of

client's business and industry

Common authorizations in the minutes include

compensation of officers, new contracts and agreements, acquisitions of property, loans, and dividend payments. Examples of other information relevant to the audit include discussions about litigation, a pending issuance of stock, or a potential merger.

When accepting clients, the CPA firm must also determine that it has the_____ , such as industry knowledge, to accept the engagement and that the firm can satisfy all ____ requirements.

competency, independence

Because materiality depends on __________ auditors must have knowledge of the likely users of the client's statements and the decisions that are being made.

decisions of users who rely on the statements to make decisions,

preliminary judgement about materiality - is called a preliminary judgement because?

despite being a professional opinion - this opinion can change during the engagement

Where does the auditor state the preliminary materiality judgement

documented in audit files

Auditing standards require auditors to decide on the combined amount of misstatements in FS that they would consider material when

early in the audit - when developing overall strategy for the audit

Auditing standards define materiality as the magnitude of misstatements that individually, or when aggregated with other misstatements, could reasonably be expected to influence the _______ ______ of _____ made on the basis of ______-

economic decisions of users financial statements

What should auditor do to be effective in

establish expectations for outcome

Sab 99 provides guidance on __ ___ auditors must account for ___ __ when concluding

evaluating materiality, qualitative factors

Many CPA firms evaluate existing clients annually to determine whether there are reasons for not continuing to do the audit. Previous conflicts over the appropriate scope of the audit, the type of opinion to issue, unpaid fees, or other matters may cause the auditor to discontinue association. The auditor may also drop a client after determining the client lacks integrity.Even if none of the previously discussed conditions exist, the CPA firm may decide not to continue doing audits for a client because of ____ ____

excessive risk

How would you determine the 5

google finance, 10k, - what type of evidence would i get to do that, client inquiry,

Audits with a low acceptable audit risk will normally result in ______ which should be reflected in _____ why?

higher audit costs, higher audit fees, more evidence

Because material related party transactions must be disclosed, all related parties need to be ____ and _____ in the auditors __ ___ early in the engagement

identified and included in the auditor's permanent files early in the engagement.

Usually financial data - from peer group

industry

Numerous potential comparisons of current- and prior-period data extend beyond those normally available from

industry data.

___ and ___ environment Includes ____ conditions, ____ requirements, industry trends, competition, environmental factors (the actual environment or their industry)

industry, external, economic, regulatory

If the client refuses to correct the statements after the auditor shows there is a mm, the auditor must do what

issue a qualified or an adverse opinion, depending on the materiality of the misstatement.

A client's performance measurement system includes______ that management uses to measure progress toward its objectives. They go beyond financial statement figures, such as sales and net income, to include measures tailored to the client and its objectives.

key performance indicators

Ex: unsure but we think allowance for doubtful acc - should be higher because of mistakes in sampling ex of what

likely misstatements

The omission or misstatement of an item in a financial report is material if, in the light of the surrounding circumstances, the ____ of the item is such that is probable that the judgement of a ___ ___ relying upon the report would have been____ or ____ by the inclusion or correction of the item

magnitude, reasonable person, changed, influenced

After performing preliminary analytical procedures, the fourth step in the audit planning process is to

make a preliminary judgment about materiality for the audit of the financial statements.

Such key performance indicators may include

market share, sales per employee, unit sales growth, unique visitors to a website, same-store sales, sales by country, and sales per square foot for a retailer.

An auditor might use ratio information to identify areas where the co faces increased risk of

material misstatements.

To make such determinations - of issuing a qualified or adverse opinion, auditors depend on a thorough knowledge of the application of ____

materiality

those things that would influence or change user's decisions

materiality

Performance materiality is defined as the amount(s) set by the auditor at less than materiality for the financial statements as a whole to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements exceeds __________

materiality for the financial statements as a whole.

For an accounts receivable balance of $1,000,000, for example, the auditor should accumulate _____ if a misstatement of $50,000 is considered material than if $300,000 were considered material.

more evidence

The lower the dollar amount of the preliminary judgement, the ....

more evidence required

What is information auditor needs to know regarding information for client acceptance

nature of business, integrity of management, previous auditor, industry or economic trends, controls, independence factors, public vs. private, types of services requested, financially viable

In first step of planning the auditor identifies the client's ____. To avoid misunderstandings, the auditor obtains an understanding with the client about the terms of the engagement in ___ ___. The auditor develops the overall ____ for the audit, including engagement ___and any required audit specialists.

needs, engagement letter, strategy, staffing

Some firms use a different primary benchmark, because _____often fluctuates considerably from year to year and therefore does not provide a stable benchmark, or when the entity is a ____ organization.

net income, non profit

Other primary benchmarks include

net sales, gross profit, and total or net assets.

In the 3rd part of audit planning the auditor

perform preliminary analytical procedures

______is inversely related to the amount of evidence an auditor will accumulate.

performance materiality

which is materiality for segments of the audit (classes of transactions, account balances, and related disclosures - for planning extent of tests

performance materiality

Because of the lack of independence between related parties, the Sarbanes-Oxley Act prohibits related party transactions that involve__ ___ to any director or executive officer of a public company.

personal loans (banks are the exceptions)

By touring the client's facilities the auditor can asses __ ___ over assets and interpret __ __ related to assets better - this allows the auditor to better be able to __ ___ from factors such as equipment or unsalable inventory

physical safeguards, accounting data, identify risks

Analytical procedures are required in what two phases

planning and completion

Be able to describe the three times analytical procedures are performed during an audit and identify the two required times.

planning, testing, completion

Analytical procedures is the analysis of __ ___ between ___ and __ ___ information to identify __ __ for future investigations

plausible relationships, financial, nonfinancial, unsual trends

When auditors decide on materiality of the combined amount of misstatements in the financial statements in the audit as they are developing the overall strategy for the audit. - this is called?

preliminary judgement about materiality

Analytical procedures set __ ___ of materiality and _ __

preliminary judgement, performance materiality

Such preliminary tests can reveal unusual changes in ratios compared to ____ or to ___ averages, and help the auditor identify areas with increased risk of misstatements that require further attention during the audit.

prior years, industry

After establishing a primary benchmark, auditors should also decide whether the misstatements could materially affect the ____ of other benchmarks such as current assets, total assets, current liabilities, and owners' equity.

reasonableness

Identify __ ___- organizations or individuals have mutual interest, no competitive tension ex: affiliated companies, officers - aware of transactions - increased risk, there is disclosure requirements, because of higher probability of ___ this is part of which element of understanding

related parties, fraud, business operations and processes

Each client is unique, clients are __ ___ and this should be re evaluated each year

risk based

Refers to overall ___ and __ of co (financial reporting, compliance with laws and regulations, efficiency and effectiveness), impact of implementing strategy. What are they trying to do, objectives included in COSO, impact of strategy. What element

strategy, objective, objectives and strategies

The burden of initiating the communication - to determine previous client acceptability rests with the

successor auditor, but the predecessor auditor is required to respond to the request for information.

Analytical procedures are done but not required in what phase

testing

A related party transaction is any transaction between

the client and a related party.

One such analytical procedure compares client ratios to industry or competitor benchmarks to provide an indication of ?

the company's performance.

For prospective clients that have previously been audited by another CPA firm, the new (successor) auditor is required by auditing standards to communicate with who, what is the purpose

the predecessor auditor. (help the successor auditor evaluate whether to accept the engagement. (can inform the successor auditor that the client lacks integrity or that there have been disputes over accounting principles, audit procedures, or fees.)

An auditor is unlikely to accept a new client or continue serving an existing client if

the risk associated with the client is greater than the risk the firm is willing to accept.

Transactions with related parties are important to auditors because accounting standards require that

they be disclosed in the financial statements if they are material.

Likely: misstatements are

things we are unsure of but we think they can be wrong.

Known misstatements are

things we find that are wrong

Why do we have an acceptance process for client

to ensure that we do have ethical clients

Why are analytical procedures done

to identify unusual or unexpected trends for future investigations

A less common example is the exercise of significant management influence on an audit client by its most important customer. - ex of what

transaction of related party

What is the risk that occurs from related parties

transactions may be valued differently than from an independent 3rd company. Co typically give good rated to related parties

t/f A transaction with a related party is not an arm's-length transaction.

true

If auditors assigned the same level of materiality to each segment of the audit that was assigned for the overall financial statements, there would likely be ____ that exceed materiality for the financial statements as a whole.

unidentified misstatements

Inherent risk of financial statement misstatements may be increased if the client has set __ ____ or if the performance measurement system encourages __ __

unreasonable objectives, aggressive accounting

Why is client business risk important to auditors

we want viable clients that wont go out of business

What does the SEC say about netting misstatements

when we have different accounts we should not net misstatements in same account

_____ is defined in auditing standards as an affiliated company, a principal owner of the client company, or any other party with which the client deals, where one of the parties can influence the management or operating policies of the other.

A related party

Analytical procedures are done in completion phase to do what

At the end of the final quality control check, piece by piece, assertion by assertion - when we put it all together - does it make sense?

What industry is an exception to the independence between related parties

Banks and other financial institutions, however, are permitted to make normal loans, such as residential mortgages, to their directors and officers using market rates.

Data from budgets is ___ determined, and gives us insight for

Client determined, how well they performed

___ financial statements allow for comparison between companies or for the same company over different time periods, revealing trends and providing insight into how different companies compare.

Common-size

What else during the tour and throughout the audit will also help the auditor learn more about the client's business to aid in assessing risk.

Discussions with non accounting employees

This element Includes ____ oversight, code of conduct, key officers, management ____and ___

Management and governance, governance, style , organization

____is often the primary benchmark for deciding what is material for profit-oriented businesses because it is regarded as a critical item of information for users.

Net income before taxes

What do we have in place for client acceptance

Quality controls standards - policies and procedures for acceptance and continuing serving clients

Investigating new clients and reevaluating existing ones is an essential part of deciding

acceptable audit risk.

In the 1st part of audit planning the auditor ___ __ and __ ___.

accepts client, begins planning

Ex: our sales are up 10% and everything else is the same, 100 stores with of - and now we have 125 stores now - expect increase in sales when is this done

analytical procedures

Performing preliminary ____ is the third step in the planning process and is discussed next.

analytical procedures

What is the purpose of conducting analytical procedures during audit planning: To be able to design __ __ to detect error equal or greater than __ __

analytical procedures, performance materiality

Setting a preliminary judgement about materiality, - helps the auditor plan what

appropriate evidence to accumulate