Audit Exam #2 Ch6.0

The terms of the engagement should include what 5 items?

(1) the objectives and scope of the audit (2) auditor and management responsibilities (3) inherent limitations of the audit (4) the applicable financial reporting framework (5) the expected form and content of reports to be issued by the auditors

What type of fraud risk is more important?

- Management Fraud OR Fraudulent financial reporting is more costly - Misappropriation of Assets (defalcations) happeds more often

What is the overall response to fraud risk? (hint 4)

1. Adjust professional skepticism and audit evidence 2. Adjust personnel assigned and supervision 3. Adjust scrutiny given to accounting principles 4. Predictability of auditing procedures

4 optional items in engagement letters

1. Arrangements regarding conduct, use of specialist or internal auditors, obtaining info from predecessor auditors, fees and billing 2. Other services to be provided 3. Limitation or other arrangements regarding the auditor's liability 4. Conditions under which access the auditors; working papers may be granted to others

What should be the response to the possibility of management override? (hint 3)

1. Examining journal entries 2. Review accounting estimates for biases 3. Evaluating the business rationale for significant unusual transactions

2 Types of Fraud Risk

1. Fraudulent financial reporting (management fraud) 2. Misappropriation of Assets (defalcations)

3 Fraud Risk Factors

1. Incentives 2. Opportunity 3. Attitude or ability to rationalize

What alterations should be made when responding to fraud risk? (hint 3)

1. More reliable evidence 2. Shifting timing to year end 3. Increasing extent (e.g., sample sizes)

Engagement letters must include ... (hint 3)

1. Name of the entity 2. Management responsibilities 3. Auditor responsibilities

6 Steps of the Audit Process (in order)*

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

What are the 6 transaction cycles?

1. Revenue (sales) and collections cycle 2. Acquisition and payments cycle 3. Conversion cycle 4. Payroll cycle 5. Investing cycle 6. Financing cycle

When obtaining clients what 2 things must be done

1. Submit a proposal 2. Communicate with the predecessor auditor

2 directions of the audti trail

1. Test for existence or occurrence 2. Test for completeness

Planning the audit is what stage of the audit and includes what

1st - Establish an understanding with the client as to the nature of the engagement. Develop the audit: strategy, plan, and program

Obtain an understanding of the client and its environment, including internal control is what stage of the audit and includes what

2nd - Perform risk assessment procedures

Assess the risks of material misstatement and design further audit procedures is what stage of the audit and includes what

3rd - Identify and asses risks of material misstatement for account balances, classes of transactions, and disclosures

Perform further audit procedures is what stage of the audit and includes what

4th - It approaches: tests of controls, analytical procedures, tests of details of transactions and balances. Audit procedures include: Inspection, inquiry, Observation, Confirmation, Recalculation, Reperformance

Complete the audit is what stage of the audit and includes what audit procedures

5th - search for unrecorded liabilities, review minutes of meetings, perform firm analytical procedures to identify loss contingencies, perform review for subsequent events, obtain representation letter, evaluate audit findings

Form an opinion and issue the audit report is what stage of the audit and includes what

6th - Public company reporting requires reporting on the internal control and on the financial statements. Nonpublic company reporting ordinarily involves only reporting on the financial statements

Representations by management that are communicated, explicitly or implicitly, in the financial statements.

Assertions

At the overall engagement level, this is the risk that the auditors may unknowingly fail to appropriately modify their opinion on financial statements that are materially misstated.

Audit RIsk

A description of the nature, timing, and extent of the audit procedures to be performed.

Audit Risk

Misstatements are material if a substantial likelihood that, individually or in the aggregate, they would influence the judgment made by a reasonable user made based on the financial statements.

Auditing Standards Board's definition of materiality

A risk that threatens management's ability to achieve the organization's objectives.

Business Risk

What should be done when fraud is discovered?

Communication to appropriate level of management. If fraud involves senior management or material misstatement communicate to audit committee

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

Consideration of fraud

Indicate whether the following factor would most likely increase, decrease, or have no effect on the risk of material misstatement. 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

Indicate whether the following factor would most likely increase, decrease, or have no effect on the risk of material misstatement. During 20X1, litigation filed against TWD from an action 10 years ago that alleged that TWD discharged pollutants into state waterways was dropped by the state. Loss contingency disclosures that TWD included in prior years' financial statements are being removed from the 20X1 financial statements.

Decrease

Indicate whether the following factor would most likely increase, decrease, or have no effect on the 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

Indicate whether the following increases or decreases the risk of material misstatement and (2) whether it creates a risk of fraud. Government regulation and overview of the banking industry is extensive and effective.

Decrease, no

Indicate whether the following increases or decreases the risk of material misstatement and (2) whether it creates a risk of fraud. Management has been receptive to Green's suggestions relating to accounting adjustments.

Decrease, no

Indicate whether the following increases or decreases the risk of material misstatement and (2) whether it creates a risk of fraud. NFB is a continuing audit client.

Decrease, no

Indicate whether the following increases or decreases the risk of material misstatement and (2) whether it creates a risk of fraud. NFB operates in a growing, prosperous area and has remained profitable over the years

Decrease, no

Indicate whether the following increases or decreases the risk of material misstatement and (2) whether it creates a risk of fraud. The accounting department has experienced little turnover in personnel during the five years Green has audited NFB.

Decrease, no

Indicate whether the following increases or decreases the risk of material misstatement and (2) whether it creates a risk of fraud. The internal auditor reports directly to Harris, a minority shareholder, who also acts as chairman of the board's audit committee.

Decrease, no

What is involved in a risk assessment?

Discussion of the audit team, elements of auditors' understanding, assessment of risk of material misstatement, and risks identified

An agreement between the CPA firm and the client as to the terms of the audit engagement

Engagement Letter

The purpose of this document is to avoid misunderstandings between the auditors and the client.

Engagement letter

The omission or misstatement of an item in a financial report is material if, in light of surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item.

FASB's definition of materiality

How to react to the risk of material misstatement

For these risks the auditors should carefully consider internal controls, not rely on controls tested in prior periods, and not rely solely on analytical procedures to obtain evidence about the related financial statement assertions. Then, the should design further audit procedures

Indicate whether the following factor would most likely increase, decrease, or have no effect on the risk of material misstatement. An initial public offering of TWD's stock is planned for late 20X2.

Increase

Indicate whether the following factor would most likely increase, decrease, or have no effect on the risk of material misstatement. During 20X1, TWD changed its method of preparing its financial statements from the cash basis to generally accepted accounting principles.

Increase

Indicate whether the following factor would most likely increase, decrease, or have no effect on the risk of material misstatement. During 20X1, TWD sold one-half of its controlling interest in United Equipment Leasing (UEL) Co. TWD retained significant influence over UEL.

Increase

Indicate whether the following factor would most likely increase, decrease, or have no effect on the risk of material misstatement. During December 20X1, TWD completed a barter transaction with a municipality. TWD removed waste from the municipally owned site and acquired title to another contaminated site at below market price. TWD intends to service this new site in 20X2.

Increase

Indicate whether the following factor would most likely increase, decrease, or have no effect on the risk of material misstatement. 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

Indicate whether the following factor would most likely increase, decrease, or have no effect on the risk of material misstatement. 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

Indicate whether the following factor would most likely increase, decrease, or have no effect on the 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

Indicate whether the following factor would most likely increase, decrease, or have no effect on the 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

Indicate whether the following factor would most likely increase, decrease, or have no effect on the risk of material misstatement. The accounting department has experienced a high rate of turnover of key personnel.

Increase

Indicate whether the following factor would most likely increase, decrease, or have no effect on the risk of material misstatement. The internal auditor reports to the controller and the controller reports to Janice Mead.

Increase

Indicate whether the following increases or decreases the risk of material misstatement and (2) whether it creates a risk of fraud. During 20X1, NFB increased the efficiency of its accounting operations by installing a new, sophisticated computer system.

Increase, yes

Indicate whether the following increases or decreases the risk of material misstatement and (2) whether it creates a risk of fraud. Interest rates have been very volatile recently.

Increase, yes

Indicate whether the following increases or decreases the risk of material misstatement and (2) whether it creates a risk of fraud. Management at the bank's branch offices has authority for directing and controlling NFB's operations and is compensated based on branch profitability.

Increase, yes

Indicate whether the following increases or decreases the risk of material misstatement and (2) whether it creates a risk of fraud. NFB's board of directors is controlled by Smith, the majority stockholder, who also acts as the chief executive officer.

Increase, yes

Indicate whether the following increases or decreases the risk of material misstatement and (2) whether it creates a risk of fraud. NFB's formula has consistently underestimated the allowance for loan losses in current years.

Increase, yes

Indicate whether the following increases or decreases the risk of material misstatement and (2) whether it creates a risk of fraud. The banking industry has been significantly impacted by the downturn in the economy in recent years.

Increase, yes

The risk of material misstatement of an assertion about an account without considering internal control

Inherent risk

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Material misstatement of financial statements by management with the intent to mislead financial statement users

Management Fraud OR Fraudulent financial reporting

Theft of client assets by an employee or officer of the organization.

Misappropriation of Assets (defalcations)

Indicate whether the following factor would most likely increase, decrease, or have no effect on the risk of material misstatement. During December 20X1, TWD increased its casualty insurance coverage on several pieces of sophisticated machinery from historical cost to replacement cost.

No effect

Indicate whether the following factor would most likely increase, decrease, or have no effect on the risk of material misstatement. TWD's employees are paid biweekly.

No effect

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.

PCAOB interpretation of federal securities laws on materiality

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

Procedure results

Discussion of the audit team, elements of auditors' understanding, assessment of risk of material misstatement, and risks identified

Risk assessment

An identified risk that requires special audit consideration.

Significant risk

Indirect and direct verification of income statement accounts is included in what portion of the audit plan?

Substantive test portion

The _____ _____ portion of the audit plan deals with financial statement account balances

Substantive test portion

Evidence of test of controls and assessment of control risk is included in what portion of the audit plan?

Systems portion

Tracing of transactions from source documents to recorded amounts

Test for completeness

Vouching transactions from recorded amounts to source documents

Test for existence or occurrence

Auditors' consideration of internal control is often organized around client's major

Transaction Cycles

The sequence of procedures applied by the client in processing a particular type of recurring transaction

Transaction cycle AKA Classes of Transactions

A trail of evidence that links original recording of a transaction, journal entries, and ledger entries

audit trail

Which of the following best describes what is meant by the term "fraud risk factor"? a. Factors that, when present, indicate that risk exists. b. Factors often observed in circumstances where frauds have occurred. c. Factors that, when present, require modification of planned audit procedures. d. Weaknesses in internal control identified during an audit.

b. Factors often observed in circumstances where frauds have occurred.

Which of the following is most likely to be an overall response to fraud risks identified in an audit? a. Supervise members of the audit team less closely and rely more upon judgment. b. Use less predictable audit procedures. c. Use only certified public accountants on the engagement. d. Place increased emphasis on the audit of objective transactions rather than subjective transactions.

b. Use less predictable audit procedures.

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? a. Generous performance-based compensation systems. b. Management preoccupation with increased financial performance. c. An unreliable accounting system. d. Strained relationships between management and competing companies.

c. An unreliable accounting system.

The primary objective of tests of details of transactions performed as substantive procedures is to: a. Comply with auditing standards. b. Attain assurance about the reliability of the accounting system. c. Detect material misstatements in the financial statements. d. Evaluate whether management's policies and procedures are operating effectively.

c. Detect material misstatements in the financial statements.

Which of the following elements underlies the application of auditing standards, particularly those related to fieldwork and reporting? a. Adequate disclosure. b. Quality control. c. Materiality and audit risk. d. Client acceptance.

c. Materiality and audit risk.

Which portion of an audit is least likely to be completed before the balance sheet date? a. Tests of controls. b. Issuance of an engagement letter. c. Substantive procedures. d. Assessment of control risk.

c. Substantive procedures.

Three conditions generally are present when fraud occurs. Select the one below that is not one of those conditions. a. Incentive or pressure. b. Opportunity. c. Supervisory position. d. Attitude.

c. Supervisory position.

Which of the following should not normally be included in the engagement letter for an audit? a. A description of the responsibilities of client personnel to provide assistance. b. An indication of the amount of the audit fee. c. A description of the limitations of an audit. d. A listing of the client's branch offices selected for testing.

d. A listing of the client's branch offices selected for testing.

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 a. Business risk. b. Engagement risk. c. Control risk. d. Detection risk.

d. Detection risk.

Which of the following should the auditors obtain from the predecessor auditors before accepting an audit engagement? a. Analysis of balance sheet accounts. b. Analysis of income statement accounts. c. All matters of continuing accounting significance. d. Facts that might bear on the integrity of management.

d. Facts that might bear on the integrity of management.

The audit committee of a company must be made up of: a. Representatives from the client's management, investors, suppliers, and customers. b. The audit partner, the chief financial officer, the legal counsel, and at least one outsider. c. Representatives of the major equity interests, such as preferred and common stockholders. d. Members of the board of directors who are not officers or employees.

d. Members of the board of directors who are not officers or employees.

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: a. Each recorded sale represents a bonafide transaction. b. All sales have been recorded in the sales journal. c. All debit entries in the accounts receivable subsidiary ledger are properly supported by sales journal entries. d. Recorded sales have been properly posted to customer accounts.

d. Recorded sales have been properly posted to customer accounts.

An amount (or disclosure) that would influence decisions that users make on the basis of the financial information of a specific reporting entity

materiality

From the auditor's perspective, it may be viewed as the amount at which the auditor believes that there is a substantial likelihood that, individually or in the aggregate, misstatements would influence the judgment of a reasonable user of the financial statements

materiality

When determining ____ use professional judgment based on that of a reasonable person considering both quantitative and qualitative factors

materiality

The _____ portion of the audit plan deals with client's internal control.

systems

An estimate of the time required to perform each step in the audit.

time budget