Chapter 5

existence/occurence

assets, liabilities, and equity interests exist and the recorded transactions have occurred

the _________ typically contains the working papers of a company

audit file

expectations

auditors develop expectations using a number of different techniques, including trend analysis, ratio analysis, regression analysis, and reasonableness tests

audit risk

auditors must obtain sufficient appropriate audit evidence to reduce audit risk to a low level in every audit

current

current year working papers and index and cross-refrencing

reliability

dependent on the circumstances in which it is obtained

specialist report

findings of an expert hired by the client or auditor to performa a highly technical valuation

analytical procedures and tests of detail of account balances, transactions, and disclosures are _______ procedures

substantive

further audit procedures

tests of controls, substantive procedures that are performed based on the results of the auditors risk assessments

test of class of transaction

tests of inventory purchases to determine if properly accounted for

rights and obligations

the company holds rights to the assets; liabilities are the obligations of the company

relevant audit evidence provides support for detecting misstatements in

the financial statement assertions being tested

ratio analysis

compare relationships between two or more financial statement accounts or comparisons of account balances to non-financial data 1. liquidity 2. leverage 3. profitability 4. activity

ratio analysis

comparisons of relationships between two or more financial statement accounts, or comparisons of account balances to non financial data

test of account balance

confirmation of accounts receivable balance

related party

individuals or entities that may have dealings with the client in which one party is significantly influenced by the other such that it may not pursue its separate interests

lawyers letter

the primary source of info about litigation that is pending against the client

observation

watching a process or procedure being performed by the entities personnel or the performance of control activities

high reliability

when something is prepared externally and sent directly to auditors. something has high reliability when it is done outside the company

to increase the reliability of evidence, the completed confirmations are sent directly to the ___________

auditor

representation letter

client provides to summarize important important assertions made by management during the audit

working papers need to be safeguarded because they contain

confidential client info

relevance

confirming a clients accounts receivable with customers may provide evidence on the existence of the receivables, but it provides very limited info relating to whether the client has completely recorded all receivable accounts

substantive procedures

detect material misstatements at relevant assertion level. including analytical procedures, and tests of details of account balances, transactions, and disclosures

something to remember:

detection risk varies inversely with the risk of material misstatement (the greater the risk of material misstatement, the less the detection risk that can be accepted by the auditors)

corroborating documents

documents that substantiate representations contained in the clients financial statements such as audit confirmations, minutes of directors meetings, and client representation letters

analytical procedure

evaluations of financial information through analysis of plausible relationships among both financial and non-financial data

accounts assertions

existence, rights/obligations, completeness, valuation and allocation

type 2 error

failing to modify opinion when there is material departure from GAAP

extent of procedures

holding other factors such as the nature and timing of procedures constant: 1. the greater the risk of material misstatement, the greater the needed extent of substantive procedures 2. the main way to increase the extent of audit procedures is to examine more items 3. sample sizes should reduce detection risk so as to restrict audit risk to a low level

detection risk has a _______ relationship with the risk of material misstatement

inverse

non-routine

involve activities that occur only periodically such as the taking of physical inventories. high inherent risk

analytical procedures

involve evaluations of financial statement info by a study of relationships among financial and non financial data

analytical procedures

involve the comparison of relationships among financial and non financial data. data interrelationships rely upon plausible relationships among both financial and non financial data. a plausible relationships may exist in an industry between annual square footage of sales space and retail space

cross-sectional analysis

involves comparisons with similar firms at a point in time, often comparing the clients ratios to industry averages

trend analysis

involves the review of changes in an account balance over time. example: a review of the clients sales for the past 3 years might reveal a consistent growth rate and this info would assist the auditors in developing an expectation about what sales should be for the current year

something to remember about the inherent risk of a company

it is not constant over time

permanent files

items of continuing audit interest

auditors obtain a variety of representation from a number of company personnel and outside parties

like client's customers, vendors, financial institutions, and attorneys. evidence may be obtained from specialists in some audits. inquiries that may be oral or written may result in either oral or written replies

type 1 audit error

modifying opinion when the financial statements are fairly stated in accordance with GAAP

factors that affect inherent risk

nature of clients environment, nature of the client, nature of the account

audit documentation should be

sufficient, to allow an experienced auditor to understand the audit work performed, the evidence obtained, and the significant conclusions reached. one who possesses the competencies and skills to perform an audit of the client, but has no previous experience with the client

primary

support the auditors' compliance with auditing standards support the auditors' opinion

test of disclosure

test of property, plant, and equipment footnotes

recalculation

testing the mathematical accuracy of documents or records

appropriateness

the measure of the quality of that audit evidence. both its relevance and reliability is considered. relevance relates to the assertion being addressed.

regression analysis

the most sophisticated expectation development technique that allows auditors to measure the reliability and precisions of the expectation

a _________ model, such as a discounted future cash flow model, can be used to determine fair value for assets that do not have active markets

valuation

audit documentation, which is the record of the audit procedures performed, relevant audit evidence obtained, and the conclusions the auditors reach are also known as:

work papers

much of the information gained in confidence by the auditors is recorded in their ________

working papers. the working papers are confidential in nature

audit evidence gathered from oral or written inquiries made by the auditor can include:

written representations from outside parties, written representations from company personnel, and oral representations from company personnel

inspection of records/documents

examining a record or document

inspection of tangible assets

physically examining an asset

AICPA requires that audit documentation provide:

1. evidence of the auditors basis for concluding on the achievement of the audits overall objectives 2. evidence that the audit was planned and performed in accordance with GAAS

2 basic approaches to ratio analysis

1. horizontal analysis 2. cross-sectional analysis

the representations usually fall into the following broad categories:

1. all accounting records, financial data, and minutes of directors meetings have been made available to the auditors 2. the financial statements are complete and were prepared in conformity with GAAP 3. management believes that the adjusting entries brought to its attention by the auditors and not recorded are not material 4. management acknowledges its responsibility to design and implement programs and controls to prevent and detect fraud and to design and implement programs and controls to prevent and detect fraud 5. all items requiring disclosure have been properly disclosed

substantive procedures

1. analytical procedures 2. test of details (test of accounts, test of transactions, test of disclosures)

three types of assertions

1. assertions about account balances (accounts) 2. assertions about classes of transactions and events (transactions) 3. assertions about presentation and disclosure (disclosure)

working papers

1. audit administrative working papers 2. working trial balance (the backbone) 3. lead schedules 4. adjusting journal entries and reclassification entries 5. reconciliations 6. supporting schedules 7. computational working papers 8. corroborating documents

general categories into which most working papers may be grouped

1. audit administrative working papers 2. working trial balance and lead schedules 3. adjusting journal entries and reclassification entries 4. supporting schedules, analyses, reconciliations, and computational working papers 5. corroborating documents

not all documents are created equal

1. created outside client firm, obtained by auditors - cash confirmations, cut-off bank statements 2. created outside client, held by client - vendor invoices 3. created within client - purchase orders, receiving reports

types of working files

1. current files 2. permanent files

there are two files of working papers for each client

1. current files for every completed audit. pertains solely to that year's audit 2. permanent file of relatively unchanging data - contains such things as copies of the articles of incorporation, which are of continuing audit interest

steps involved:

1. develop expectation of account balance 2. determine amount of difference that can be accepted without investigation 3. compare the company's account with the expectation 4. investigate and evaluate significant differences

high inherent risk:

1. difficult to audit transactions or balances 2. complex calculations 3. difficult accounting issues 4. significant judgment by management 5. valuations that vary significantly based on economic factors

related party transactions

1. disclosure requirements must be met 2. primary challenge is identifying undisclosed related party transactions

rank the inherent risk from the different type of transactions from highest to lowest

1. estimation 2. non routine 3. routine

appropriateness of evidence

SUFFICIENT APPROPRIATE EVIDENCE. to be appropriate audit evidence must be relevant and reliable. (relevance relates to the assertion being addressed - evidence to support existence, completeness)

inspection of records/documents

a procedure found everywhere throughout the audit

horizontal analysis

a review of client financial statement amounts and ratios over time

for each topic

a separate, properly identified working paper should be prepared for each topic. proper identification is accomplished by a heading.

presentation/disclosure

accounts are described and classified in accordance with GAAP, and financial disclosures are complete, appropriate and clear

estimation transactions

activities that create accounting estimates. higher inherent risk

completeness

all assets, liabilities, equity interests, and appropriate transactions have been recorded

audit evidence

all the info used by the auditors in arriving at the conclusions on which the audit opinion is based. includes the info contained in the accounting records underlying the financial statements and other info

valuation/allocation/accuracy

all transactions, assets, liabilities, and equity interests are included in the financial statements at proper amounts

accounting estimates example

allowances for loan losses and obsolete inventory and estimates of warranty liabilities

audit documentation should be sufficient to allow ________ to understand the audit performed, the evidence obtained and the significant conclusions reached

an experienced auditor

reperformance

an independent execution of proceures or controls that were originially performed by the client

nature and timing of procedures

holding the extent of procedures constant, one may increase the scope of procedures (make them more effective) by changing either: 1. nature - obtain more reliable evidence (externally generated) 2. timing - wait until year-end to obtain evidence from entire set of transactions as contrasted to performing interim testing

goal in auditing

in auditing their clients fair values, auditors should keep in mind that the goal is to achieve a fair value and to determine that valuation techniques are consistently applies, or if revisions are needed they are accounted for as a change in accounting estimate

audit file

includes the working papers for a particular engagement and is the principal record of the work performed during the audit.

existence assertion

inspections of tangible assets provide high quality evidence

inquires of specialists

the necessity for auditors to consult with experts, when appropriate as a means of gathering sufficient appropriate audit evidence. expertise in valuation of complex financial instruments and other assets, actuarial calculations, estimation, and valuation. the specialist may be hired by the client

audit risk

the possibility that the auditors may unknowingly fail to appropriately modify their opinion on financial statements that are materially misstated

fair value

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

sufficient appropriate audit evidence?

the quantity needed is affected by the risk of misstatements (the greater the risk, the more audit evidence required) and also the reliability of the evidence

audit documentation (working papers)

the record of the audit procedures performed, relevant audit evidence obtained, and the conclusions the auditors reach. may be recorded on paper or on electronic or other media

audit risk

the risk that auditors will issue an unqualified opinion on financial statements that contain a material departure from GAAP

confirmation requests

these can be sent to third parties and can be used to address any of the assertions about a particular financial statement amount. they do not address all assertions equally well. they are effective at providing evidence about the assertion of existence of accounts, but they are less effective at addressing the completeness and the appropriate valuation.

cutoff

transactions and events have been recorded in the correct accounting period

scanning

use of professional judgment to review accounting data to identify significant unusual items that will be tested

regression analysis

use of stat models to quantify the auditors expectation about a financial statement amount or ratio

inquiry of specialists

1. may be hired by client or auditor 2. must evaluate qualifications and reputation 3. must review methods and assumptions 4. test the accuracy of source data used by specialists examples: actuarial determination of pension liabilities, valuation of specialized inventory

approaches to ratio analysis

1. horizontal analysis - review ratios over time 2. cross sectional analysis - analyze ratios of similar firms at a point in time 3. vertical analysis - analyze relationships within a period, common size statements prepared

inquiry of knowledgeable persons

1. important and relevant 2. less reliable - dont believe everything you hear 3. after SOX, illegal to mislead auditors 4. representation letter formalizes many of the important oral representations

business characteristics indicative of high inherent risk:

1. inconsistent profitability of client 2. operating results highly sensitive to economic factors 3. going concern problems 4. large known and likely misstatements detected in prior audits 5. substantial turnover, questionable reputation, inadequate accounting skills of management

the audit risk model is a function of:

1. inherent risk 2. control risk 3. detection risk

ratio analysis 4 categories:

1. liquidity ratios (current ratio, quick ratio) 2. leverage ratios (debt to equity ratio, long term debt ratio) 3. profitability ratio (gross profit percentage) 4. activity ratios (inventory turnover)

one may change the scope of the audit procedures by changing the:

1. nature (type and form) 2. timing (when performed) 3. extent (quantity of evidence obtained)

factors that affect inherent risk

1. nature of the client and its environment 2. nature of the particular financial statement element

disclosure of related party transactions should include

1. nature of the relationship 2. a description of the transactions 3. amounts due to and from related parties

risk assessment procedures

1. obtain understanding of client and environment 2. understand internal control, to assess the risks of material misstatement 3. understand the company, industry, regulators, competitive environment 4. understand internal business processes 5. evaluate management (experience, tenure, reputation) 6. consider prior audit adjustments and results

when is audit evidence more reliable?

1. obtained from independent sources outside the company 2. generated through a system of effective controls rather than ineffective 3. obtained directly by the auditor rather than indirectly or by inference 4. documentary in form rather than oral 5. original documents rather than copies ALWAYS KNOW THE SOURCE OF INFO

functions of audit documentation

1. primary functions 2. secondary functions

developing an expectation

1. prior period info 2. anticipated results 3. relationships among elements of financial information within a period 4. industry info 5. relationships between financial info and relevant non-financial data

approaches to auditing estimates

1. review and test managements process for developing the estimate 2. independently develop an estimate to compare 3. review subsequent events or transactions bearing on the estimate

timing of analytical procedures

1. risk assessment 2. substantive procedures 3. final review

auditors perform these types of procedures

1. risk assessment procedures - designed to obtain an understanding of the client and its environment, including its internal control, to assess the risks of material misstatement 2. test of controls - to test the operating effectiveness of controls in preventing or detecting material misstatements 3. substantive procedures - to detect material misstatements of relevant assertions (they include analytical procedures and tests of details of accounts, transactions, disclosures)

types of transactions:

1. routine 2. non-routine 3. estimation transactions

other audit procedures

1. test controls 2. substantive procedures

sufficiency of documentation

1. there needs to be working papers or just work papers 2. should include all significant findings and the actions taken to address them 3. should be sufficient to: enable an experienced auditor to understand the work performed and the significant conclusions reached, identify who performed and reviewed the work, show that the accounting agree or reconcile to the financial statements

analytical procedures (types of analyses)

1. trend analysis 2. ratio analysis

test of controls

1. understand and document controls 2. when appropriate, test the operating effectiveness of controls in preventing material misstatements

sufficient

quantity of evidence that the auditors should obtain. auditors perform audit procedures to obtain audit evidence that will allow them to draw reasonable conclusions as to whether the clients financial statements follow GAAP.

substantive procedures

analytical procedures and tests of details. these tests are part of the auditors further audit procedures because their nature, timing and extent are based on the results of the risk assessment procedures

trend analysis

analyze changes in accounts of a company over time

related party transaction

any transaction between the company and these parties

secondary

assist continuing and new audit team members in planning and performing the audit record of matter of continuing audit interest assists in supervision and review of the audit demonstrates accountability of team members assists internal reviewers, external peer reviewers, PCAOB inspectors, and successor auditors in performing their roles

representation letter

at the conclusion of the audit, the CPA's obtain from client officers a written representation letter summarizing the most important oral representations made by management during the engagement

external confirmation

obtaining a written response about a particular item from a third party

transaction assertions

occurence, completeness, accuracy, cutoff, classification

disclosure

occurence, rights/obligations,completeness, accuracy and valuation, classification and understandability

related parties

officers, directors, principal owners, members of their immediate families

inherent risk

possibility of material misstatement of an assertion before considering the clients internal control

auditing standards allow either a _________ or __________ approach

quantified, non quantitative

routine transactions

recurring financial statement activities recorded in the accounting records in the normal course of business. there is lower inherent risk

related party transaction

refers to individuals or entities who may have dealings with the client in which one party is significantly influenced by the other such that it may not pursue its separate interest

common methods for auditors to determine related parties include:

reviewing SEC filings inquiries of management conflict of interest statements

inherent risk

risk of a material misstatement occurring in an assertion assuming no related internal controls

audit risk = risk of material misstatement (x) risk auditors fail to detect material misstatement

risk of material misstatement = inherent risk (x) control risk risk auditors fail to detect material misstatement = detection risk

control risk

risk that a material misstatement in an assertion will not be prevented or detected on a timely basis by the company's internal control

detection risk

risk that the auditor's procedures will lead them to conclude that a material misstatement does not exist in an assertion when in fact such misstatement does exist

detection risk

risk that the auditors procedures will not detect a material misstatement that exists in a relevant assertion. does not exist when no audit it performed. auditors try to restrict it

turnover

sales/[(begin AR+ending AR)/2]

inquiry

seeking information of knowledgable persons within or outside the organization, inquiry may be written or oral