Download Auditing Exam 1 Questions with Verified Answers,100% CORRECT and more Exams Business Economics in PDF only on Docsity! Auditing Exam 1|359 Questions with Verified Answers 1. Which of the following would be considered an assurance engagement? a. Giving an opinion on a prize promoter's claims about the amount of sweepstakes prizes awarded in the past. b. Giving an opinion on the conformity of the financial statements of a university with generally accepted accounting principles. c. Giving an opinion on the fair presentation of a newspaper's circulation data. d. Giving assurance about the average drive length achieved by golfers with a client's golf balls. e. All of the above. - CORRECT ANSWER E 2. It is always a good idea for auditors to begin an audit with the professional skepticism characterized by the assumption that a. A potential conflict of interest always exists between the auditor and the management of the enterprise under audit. b. In audits of financial statements, the auditor acts exclusively in the capacity of an auditor. c. The professional status of the independent auditor imposes commensurate professional obligations. d. Financial statements and financial data are verifiable. - CORRECT ANSWER A 3. In an attestation engagement, a CPA practitioner is engaged to a. Compile a company's financial forecast based on management's assumptions without expressing any form of assurance. b. Prepare a written report containing a conclusion about the reliability of a management assertion. c. Prepare a tax return using information the CPA has not audited or reviewed. d. Give expert testimony in court on particular facts in a corporate income tax controversy. - CORRECT ANSWER C 4. A determination of cost savings obtained by outsourcing cafeteria services is most likely to be an objective of a. Environmental auditing. b. Financial auditing. c. Compliance auditing. d. Operational auditing. - CORRECT ANSWER D 5. The primary difference between operational auditing and financial auditing is that in operational auditing a. The operational auditor is not concerned with whether the audited activity is generating information in compliance with financial accounting standards. b. The operational auditor is seeking to help management use resources in the most effective manner possible. c. The operational auditor starts with the financial statements of an activity being audited and works backward to the basic processes involved in producing them. d. The operational auditor can use analytical skills and tools that are not necessary in financial auditing. - CORRECT ANSWER B 6. According to the AICPA, the purpose of an audit of financial statements is to a. Enhance the degree of confidence that intended users can place in the financial statements. b. Express an opinion on the fairness with which they present financial position, results of operations, and cash flows in conformity with accounting standards promulgated by the Financial Accounting Standards Board. c. Express an opinion on the fairness with which they present financial position, results of operations, and cash flows in conformity with accounting standards promulgated by the U.S. Securities and Exchange Commission. d. Obtain systematic and objective evidence about financial assertions and report the results to interested users. - CORRECT ANSWER A 7. Bankers who are processing loan applications from companies seeking large loans will probably ask for financial statements audited by an independent CPA because a. Financial statements are too complex for the bankers to analyze themselves. b. They are too far away from company headquarters to perform accounting and auditing themselves. c. The consequences of making a bad loan are very undesirable. d. They generally see a potential conflict of interest between company managers who want to get loans and the bank's needs for reliable financial statements. - CORRECT ANSWER D e. Occurrence. - CORRECT ANSWER A 18. When auditing merchandise inventory at year-end, the auditor performs audit procedures to obtain evidence that no goods held on consignment are included in the client's ending inventory balance. This audit procedure provides assurance about which management assertion? a. Completeness. b. Existence. c. Valuation and allocation. d. Rights and obligations. e. Occurrence. - CORRECT ANSWER D 19. When an auditor reviews additions to the equipment (fixed asset) account to make sure that fixed assets are not overstated, she wants to obtain evidence as to management's assertion regarding a. Completeness. b. Existence. c. Valuation and allocation. d. Rights and obligations. e. Occurrence. - CORRECT ANSWER B 20. The Sarbanes-Oxley Act of 2002 generally prohibits public accounting firms from a. Acting in a managerial decision-making role for an audit client. b. Auditing the firm's own work on an audit client. c. Providing tax consulting to an audit client without audit committee approval. d. All of the above. - CORRECT ANSWER D 21. Substantial equivalency refers to a. An auditor's tendency not to believe management's assertions without sufficient corroboration. b. Providing consulting work for another firm's audit client in exchange for the other firm's providing consulting services to one of your clients. c. The waiving of certification exam parts for an individual holding an equivalent certification from another professional organization. d. Permitting a CPA to practice in another state without having to obtain a license in that state. - CORRECT ANSWER D 22. Which of the following best describes the relationship between auditing and attestation engagements? a. Auditing is a subset of attestation engagements that focuses on the certification of financial statements. b. Attestation is a subset of auditing that provides lower assurance than that provided by an audit engagement. c. Auditing is a subset of attestation engagements that focuses on providing clients with advice and decision support. d. Attestation is a subset of auditing that improves the quality of information or its context for decision makers. - CORRECT ANSWER A 23. During an audit of a company's cash balance on a company with operations in only one country, the auditor is most concerned with which management assertion? a. Existence. b. Rights and obligations. c. Valuation or allocation. d. Occurrence. - CORRECT ANSWER A 24. When auditing an investment in another company, an auditor most likely would seek to conduct which audit procedure to help satisfy the valuation assertion? a. Inspect the stock certificates evidencing the investment. b. Examine the audited financial statements of the investee company. c. Review the broker's advice or canceled check for the investment's acquisition. d. Obtain market quotations from The Wall Street Journal or another independent source. - CORRECT ANSWER D 25. Cutoff tests designed to detect valid sales that occurred before the end of the year but have been recorded in the subsequent year would provide assurance about management's assertion of a. Presentation and disclosure. b. Completeness. c. Rights and obligations. d. Existence. - CORRECT ANSWER B 26. Which of the following audit procedures probably would provide the most reliable evidence related to the entity's assertion of rights and obligations for the inventory account? a. Trace test counts noted during physical count to the summarization of quantities. b. Inspect agreements for evidence of inventory held on consignment. c. Select the last few shipping advices used before the physical count and determine whether the shipments were recorded as sales. d. Inspect the open purchase order file for significant commitments to consider for disclosure. - CORRECT ANSWER B 27. In auditing the accrued liabilities account on the Balance Sheet, an auditor's procedures most likely would focus primarily on management's assertion of a. Existence or occurrence. b. Completeness. c. Presentation and disclosure. d. Valuation or allocation. - CORRECT ANSWER B 1. Auditing Engagement 2. Attestation Engagement 3. Assurance Engagement 4. Consulting Services Engagement a. Any information Financial statements Advice and decision support Financial information b. Financial information Advice and decision support Financial statements Any information c. Advice and decision support Any information Financial information Financial statements d. Financial statements Financial information Any information Advice and decision support - CORRECT ANSWER D 29. Which of the following is a reason to obtain professional certification? a. Certification provides credibility that an individual is technically competent. b. Certification often is a necessary condition for advancement and promotion within a professional services firm. c. Obtaining certification is often monetarily rewarded by an individual's employer. d. All of the above. - CORRECT ANSWER D 39. Ordinarily, what source of evidence should least affect audit conclusions? a. External documentary evidence. b. Inquiry of management. c. Documentation prepared by the audit team. d. Inquiry of entity legal counsel. - CORRECT ANSWER B 40. The most reliable evidence regarding the existence of newly acquired computer equipment is a. Inquiry of management. b. Documentation prepared externally. c. Evaluation of the client's procedures. d. Physical observation. - CORRECT ANSWER D 41. Which of the following procedures would provide the most reliable audit evidence? a. Inquiries of the client's internal audit staff. b. Inspection of prenumbered client purchase orders filed in the vouchers payable department. c. Inspection of vendor sales invoices received from client personnel. d. Inspection of bank statements obtained directly from the client's financial institution. - CORRECT ANSWER D 42. Breaux & Co. CPAs require that all audit documentation indicate the identity of the preparer and the reviewer. This procedure provides evidence relating to which of the following? a. Independence. b. Adequate competence and capabilities. c. Adequate planning and supervision. d. Gathering sufficient appropriate evidence. - CORRECT ANSWER C 43. Which of the following concepts is least related to the standard of due care? a. Independence in fact. b. Professional skepticism. c. Prudent auditor. d. Reasonable assurance. - CORRECT ANSWER D 44. The evidence considered most appropriate by auditors is best described as a. Internal documents such as sales invoice copies produced under conditions of strong internal control. b. Written representations made by the president of the entity. c. Documentary evidence obtained directly from independent external sources. d. Direct personal knowledge obtained through physical observation and mathematical recalculation. - CORRECT ANSWER D 45. Auditors' understanding of the internal control in an entity provides information for a. Determining whether members of the audit team have the required competence and capabilities to perform the audit. b. Ascertaining the independence in mental attitude of members of the audit team. c. Planning the professional development courses the audit staff needs to keep up to date with new auditing standards. d. Planning the nature, timing, and extent of substantive procedures on an audit. - CORRECT ANSWER D 46. Which of the following elements of a system of quality control is related to firms receiving independence confirmations from its professionals with respect to clients? a. Acceptance and continuance of client relationships and specific engagements. b. Engagement performance. c. Monitoring. d. Relevant ethical requirements. - CORRECT ANSWER D 47. Which of the following is most closely related to the responsibilities principle? a. The auditors' responsibility to issue a report as a result of their examination. b. The requirement that auditors gather sufficient, appropriate evidence upon which to base an opinion on the financial statements. c. The auditors' compliance with relevant ethical requirements of independence and due care. d. The auditors' responsibility to plan the audit and properly supervise assistants. - CORRECT ANSWER C 48. Kramer, CPA, consulted an independent appraiser regarding the valuation of fine art for a not-for-profit museum. Consultation with the appraiser in this case would a. Be considered as exercising proper due care. b. Be considered a failure to follow generally accepted auditing standards because Kramer should have known how to value fine art before accepting the engagement. c. Not be considered a violation of generally accepted auditing standards because generally accepted auditing standards does not apply to not-for-profit entities. d. None of the above. - CORRECT ANSWER A 49. Which of the following topics is not addressed in the auditors' report for a public entity? a. Responsibilities of the auditor and management in the financial reporting process. b. Absolute assurance regarding the fairness of the entity's financial statements in accordance with GAAP. c. A description of an audit engagement. d. A summary of the auditors' opinion on the effectiveness of the entity's internal control over financial reporting. - CORRECT ANSWER B 50. Which of the following recognizes that an audit conducted under generally accepted auditing standards may not detect all material misstatements? a. Absolute assurance. b. Professional judgment. c. Reliability of audit evidence. d. Reasonable assurance. - CORRECT ANSWER D 51. Which of the following combinations would provide the auditor the most reliable evidence? Source of Evidence Effectiveness of Internal Control a. Internal More effective b. Internal Less effective c. External More effective d. External Less effective - CORRECT ANSWER C 59. Which of the following principles is most closely associated with the auditors' conclusion as to the fair presentation of the entity's financial statements? a. Communication principle. b. Performance principle. c. Reporting principle. d. Responsibilities principle. - CORRECT ANSWER C 60. When initiating communications with predecessor auditors, prospective auditors should expect a. To take responsibility for obtaining the client's consent for the predecessor to give information about prior audits. b. To conduct interviews with the partner and manager in charge of the predecessor public accounting firm's engagement. c. To obtain copies of some or all of the predecessor auditors' audit documentation. d. All of the above. - CORRECT ANSWER D 61. Generally accepted auditing standards require that auditors always prepare and use a. A written planning memorandum explaining the auditors' understanding of the client's business. b. A written client consent to discuss audit matters with prospective auditors. c. A written audit plan. d. The written time budgets and schedules for performing each audit. - CORRECT ANSWER C 62. When planning an audit, which of the following is not a factor that affects auditors' decisions about the quantity, type, and content of audit documentation? a. The auditors' need to document compliance with generally accepted auditing standards. b. The auditors' need to verify the existence of new sales contracts important for the client's business. c. The auditors' judgment about their independence with regard to the client. d. The auditors' judgments about materiality. - CORRECT ANSWER C 63. Audit documentation that shows the detailed evidence and procedures regarding the balance in the accumulated depreciation account for the year under audit will be found in the a. Current file audit documentation. b. Permanent file audit documentation. c. Administrative audit documentation in the current file. d. Planning memorandum in the current file. - CORRECT ANSWER A 64. An auditor's permanent file audit documentation most likely will contain a. Internal control analysis for the current year. b. The most recent engagement letter. c. Memoranda of conference with management. d. Excerpts of the corporate charter and bylaws. - CORRECT ANSWER D 65. Which of the following is not a benefit claimed for the practice of determining materiality in the initial planning stage of an audit? a. Being able to fine-tune the audit work for effectiveness and efficiency. b. Avoiding the problem of doing more work than necessary (overauditing). c. Being able to decide early what type of audit opinion to issue. d. Avoiding the problem of doing too little work (underauditing). - CORRECT ANSWER C 66. Spreadsheet software would be most useful for which of the following audit activities? a. Testing internal controls over computerized accounting applications. b. Preparing an audit plan. c. Preparing a comparison of current-year expenses with those from the previous year. d. Drafting a planning memorandum. - CORRECT ANSWER C 67. Which of the following is an advantage of computer-assisted audit techniques (CAATs)? a. All the CAATs programs are written in one computer language. b. The software can be used for audits of clients that use differing computer equipment and file formats. c. The use of CAATs has reduced the need for the auditor to study input controls for computer-related procedures. d. The use of CAATs can be substituted for a relatively large part of the required testing. - CORRECT ANSWER B 68. A primary advantage of using CAATs in the audit of an advanced computerized system is that it enables the auditor to a. Substantiate the accuracy of data through self-checking digits and hash totals. b. Utilize the speed and accuracy of the computer. c. Verify the performance of machine operations that leave visible evidence of occurrence. d. Gather and store large amounts of supportive audit evidence in machine- readable form. - CORRECT ANSWER B 69. An audit engagement letter should normally include which of the following matters of agreement between the auditor and the client? a. Schedules and analyses to be prepared by the client's employees. b. Methods of statistical sampling the auditor will use. c. Specification of litigation in progress against the client. d. Client representations about availability of all minutes of meetings of the board of directors. - CORRECT ANSWER A 70. When auditing Vandalay Jewelry, Costanza, CPA, was not familiar with the quality and cut of the company's precious jewel inventory. To address this shortcoming, Costanza hired Benes, an expert in jewel valuation, to assist as an audit specialist for the inventory valuation. Should Costanza refer to Benes's work in the audit report? a. Yes, the auditors' report should mention the fact that an audit specialist was used. b. The auditors' report should mention the use of the audit specialist only when the audit specialist's findings affect the auditors' conclusions. c. The use of an audit specialist need not be mentioned if the auditors decide not to take responsibility for the audit specialist's findings. d. The auditors' report should mention the audit specialist only if Vandalay agrees with the audit specialist's findings. - CORRECT ANSWER B 71. Which of the following engagement planning procedures would most likely assist the auditor in identifying related-party transactions before the balance- sheet date? d. Evidence of a conservative systematic bias. - CORRECT ANSWER D 81. Which of the following would be considered an analytical procedure? a. Testing purchasing, shipping, and receiving cutoff activities. b. Comparing inventory balances to recent sales activities. c. Projecting the deviation rate of a statistical sample to the population. d. Reconciling physical counts to perpetual records and general ledger balances. - CORRECT ANSWER B 82. Which of the following procedures would a CPA most likely perform in planning a financial statement audit? a. Make inquiries of the client's lawyer concerning pending litigation. b. Perform cutoff tests of cash receipts and disbursements. c. Compare financial information with nonfinancial operating data. d. Recalculate the prior-years' accruals and deferrals. - CORRECT ANSWER C 83. Which of the following statements is correct concerning analytical procedures used in planning an audit engagement? a. They often replace the tests of controls that are performed to assess control risk. b. They typically use financial and nonfinancial data aggregated at a high level. c. They usually involve the comparison of assertions developed by management to ratios calculated by an auditor. d. They are often used to develop an auditor's preliminary judgment about materiality. - CORRECT ANSWER B 84. The company being audited has an internal auditor who is both competent and objective. The independent auditor wants to assign tasks for the internal auditor to perform. Under these circumstances, the independent auditor may a. Allow the internal auditor to perform certain tests of internal controls. b. Allow the internal auditor to audit a major subsidiary of the company. c. Not assign any task to the internal auditor because of the internal auditor's lack of independence. d. Allow the internal auditor to perform analytical procedures but not be involved with any tests of details. - CORRECT ANSWER A 85. Which of the following conditions most likely would pose the greatest risk in accepting a new audit engagement? a. Staff will need to be rescheduled to cover this new client. b. There will be a client-imposed scope limitation. c. The firm will have to hire a specialist in one audit area. d. The client's financial reporting system has been in place for 10 years. - CORRECT ANSWER B 86. Auditors are interested in having independence in appearance because a. They want to impress the public with their independence in fact. b. They want the public at large to have confidence in the profession. c. They need to comply with the fundamental principles of GAAS. d. Audits should be planned and properly supervised. - CORRECT ANSWER B 87. Under Sarbanes-Oxley and PCAOB rules, ensuring that the auditor is independent in appearance is the responsibility of a. The public accounting firm. b. Senior management. c. The audit committee. d. The PCAOB. - CORRECT ANSWER C 88. If a public accounting firm says it always follows the rule that requires adherence to FASB pronouncements in order to give a standard unmodified auditors' report, it is following a philosophy characterized by a. The imperative principle. b. The utilitarian principle. c. Virtue ethics. d. Reliance on members' collective conscience. - CORRECT ANSWER A 89. Which of the following agencies issues independence rules for the auditors of public companies? a. Financial Accounting Standards Board (FASB). b. Government Accountability Office (GAO). c. Public Company Accounting Oversight Board (PCAOB) d. AICPA Accounting and Review Services Committee (ARSC). - CORRECT ANSWER C 90. Audit independence in fact is most clearly lost when a. A public accounting firm audits competitor companies in the same industry (e.g., Coca-Cola and Pepsi). b. An auditor agrees to the argument made by the client's financial vice president that deferring losses on debt refinancing is in accordance with generally accepted accounting principles. c. An audit team fails to discover the client's misleading omission of disclosure about permanent impairment of asset values. d. A public accounting firm issues a standard unmodified report, but the reviewing partner fails to notice that the assistant's observation of inventory was woefully incomplete. - CORRECT ANSWER B 91. The audit committee's responsibility for auditor independence concerns a. Ensuring that partners of the public accounting firm are not stockholders in the company. b. Ensuring that nonaudit services provided by the auditor do not impair independence. c. Reporting on auditor independence to the PCAOB. d. Ensuring that all nonaudit services are provided by auditors who do not perform the financial statement audit. - CORRECT ANSWER B 92. AICPA members who work in industry and government must always uphold which two of the following AICPA rules of conduct? a. The Independence Rule. b. The Integrity and Objectivity Rule. c. The Confidential Client Information Rule. d. The Acts Discreditable Rule. - CORRECT ANSWER B & D 93. A public accounting firm's independence is not impaired when members of the audit engagement team does which of the following for a public company audit client? a. Prepares special purchase orders for active plutonium in secure national defense installations. b. Completes operational internal audit assignments under the directions of the client's director of internal auditing. c. Prepares outsourced internal audit work on the client's financial accounting control monitoring. 101. The AICPA removed its general prohibition of CPAs taking commissions and contingent fees because a. CPAs prefer more price competition to less. b. Commissions and contingent fees enhance audit independence. c. Nothing is inherently wrong about the form of fees charged to nonaudit clients. d. Objectivity is not always necessary in accounting and auditing services. - CORRECT ANSWER C 102. CPA Kara Rambo is the auditor of Ajax Corporation. Her audit independence will not be considered impaired if she a. Owns $1,000 worth of Ajax stock. b. Has a husband who owns $1,000 worth of Ajax stock. c. Has a sister who is the financial vice president of Ajax. d. Owns $1,000 worth of the stock of Pericles Corporation, which is controlled by Ajax as a result of Ajax's ownership of 40 percent of Pericles' stock, and Pericles contributes 3 percent of its total assets and income in Ajax's financial statements. - CORRECT ANSWER D 103. When a client's financial statements contain a material departure from an FASB Statement on Accounting Standards and the public accounting firm believes the departure is necessary to ensure that the statements are not misleading, a. The public accounting firm must qualify the auditors' report for a departure from GAAP. b. The public accounting firm can explain why the departure is necessary and then give an unmodified opinion paragraph in the auditors' report. c. The public accounting firm must give an adverse auditors' report. d. The public accounting firm can give the standard unmodified auditors' report with an unmodified opinion paragraph. - CORRECT ANSWER B 104. Which of the following would not be considered confidential information obtained in the course of an engagement for which the client's consent would be needed for disclosure? a. Information about whether a consulting client has paid the CPA's fees on time. b. The actuarial assumptions used by a tax client in calculating pension expense. c. Management's strategic plan for next year's labor negotiations. d. Information about material contingent liabilities relevant for audited financial statements. - CORRECT ANSWER D 105. Which of the following would probably not be considered an "act discreditable to the profession"? a. Numerous moving traffic violations. b. Failing to file the CPA's own tax return. c. Filing a fraudulent tax return for a client in a severe financial difficulty. d. Refusing to hire Asian Americans in an accounting practice. - CORRECT ANSWER A 106. According to the AICPA Code of Conduct, which of the following acts is generally forbidden to CPAs in public practice? a. Purchasing bookkeeping software from a high-tech development company and reselling it to tax clients. b. Being the author of a "TaxAid" newsletter promoted and sold by a publishing company. c. Having a commission arrangement with an accounting software developer to receive 4 percent of the price of programs recommended and sold to audit clients. d. Engaging a marketing firm to obtain new financial planning clients for a fixed fee of $1,000 for each successful contact. - CORRECT ANSWER C 107. A CPA's legal license to practice public accounting can be revoked by the a. American Institute of Certified Public Accountants. b. State society of CPAs. c. Auditing Standard Board. d. State board of accountancy. - CORRECT ANSWER D 108. According to the Acts Discreditable Rule for accountants in public practice, which of the following is not a "discreditable act"? a. Withholding a client's sales records. b. Failing to file or remit tax payments. c. Failing to follow requirements of the PCAOB during the audit of an SEC client. d. Advertising that indicated the firm can reduce IRS penalties. - CORRECT ANSWER D 109. An auditor's independence would not be considered impaired if she or he had a. Owned common stock of the audit client but sold it before the company became a client. b. Sold short the common stock of an audit client while working on the audit engagement. c. Served as the company's treasurer for six months during the year covered by the audit but resigned before the company became a client. d. Performed the bookkeeping and financial statement preparation for the company, which had no accounting personnel and for which the president had no understanding of accounting principles. - CORRECT ANSWER A 110. When a CPA knows that a tax client has skimmed cash receipts and not reported the income in the federal income tax return but signs the return as a CPA who prepared the return, the CPA has violated which of the following AICPA rules of conduct? a. The Confidential Client Information Rule. b. The Integrity and Objectivity Rule. c. The Independence Rule. d. The Accounting Principles Rule. - CORRECT ANSWER B 111. An accountant recommends a local computer company to a client that is trying to upgrade its computerized sales records. The client purchases $25,000 worth of equipment and sends a check to the accountant for 5 percent of the total sales. This is an example of a a. Commission. b. Contingent fee. c. Referral fee. d. Nonaudit fee. - CORRECT ANSWER A 112. Which of the following ownership situations is permissible for a public accounting firm? a. A partner of the firm is responsible for fraud issues related to audits and audit clients. He owns 20 percent of the firm and is not a CPA. b. Because the firm now specializes in fraud auditing and fraud investigation, the managing partner of the firm has a background in law enforcement and fraud investigation but is not a CPA. what do financial statements represent? - CORRECT ANSWER Financial statements represent management's report to the current and potential owners (stockholders) regarding how well management has managed the owners' assets Information Risk 3 leads to demand for.. - CORRECT ANSWER The likelihood that information is not fairly stated (is false or misleading) • It contains some sort of misstatement or misrepresentation • Either due to error or fraud. • Leads to demand for... auditing?? principal agent with auditor what does info assymetry result in what does principal vs agent do - CORRECT ANSWER principal owner, agent manager info asymmetry and conflicts of interest --> info risk for the principal agent accountable to principal, provides financial reports pricnipal provides capital and hires agent to manage resources agent hires auditor to report on the fairness of agent's financial reports. agent pays auditor to reduce principal's information risk auditor gathers evidence to evaluate fairness of agent's financial reports. auditor issues audit opinon to acocmpnay agent's ifnancial reports, adding credibility to reports and reducing principals info risk Chain of Events Initial problem is Moral Hazard explain result is act in... how battle this? - CORRECT ANSWER Lack of incentive to avoid risk when one is protected from its consequence • e.g., Treasury department let Lehman brothers fail • It is not the CEO's resources that he or she is investing • Acting in self interest • Conflict of Interest • Occurs when an individual or organization is involved in multiple interests, one of which could possibly corrupt the motivation for an act in the other use accounting to battle this but problem with accounting ?? chain of events starting with principal/agent relationship (6 total) - CORRECT ANSWER principal/agent relationship --> moral hazard problem (includes information asymmetry and potentially conflicting interest) --> demand for accounting --> informaiton risk --> demand for assurance --> demand for auditing ASSURANCE DEMAND & SUPPLY (CONT.) AND THE AUDIT LANDSCAPE - CORRECT ANSWER Why would a company purchase an audit if not required by regulation? 2 , 3 under first 1 under second - CORRECT ANSWER 1.Lower Cost of Capital • Less Discounting by Equity Investors • Lower Interest Rates from Lenders • More Sources of Capital • Some Investors/Lenders are so risk averse that no risk premium is high enough to make an investment without an audit • 2.Monitor CFO and Accounting Department • Fraud, Errors audit hypotheses - wanda wallace 3 - CORRECT ANSWER Stewardship/Monitoring Hypothesis • Information Hypothesis • Insurance Hypothesis What is Auditing? types of audits 6 - CORRECT ANSWER Process of investigating something to ascertain whether it is as it should be • Types of audits • IRS Audit • Compliance Audit • Operational Audit • Fraud Audit • Financial Statement Audit • Internal Control Audit Financial Statement Audit - purpose - CORRECT ANSWER Our focus • Purpose • Process of investigating an organization's financial statements to ascertain whether they are • Fairly stated • In accordance with GAAP What Does Financial Statement Auditing Involve? 7 - CORRECT ANSWER • Understanding financial statements and accounting systems • Understanding accounting principles and accounting standards • Understanding economics and organizations • Understanding internal controls and corporate governance • Understanding misstatement risk and red flags • Understanding materiality • Understanding evidence • What does it mean? • What does it show? What Does Financial Statement Auditing Involve? 8 - CORRECT ANSWER Working with people • Thinking creatively • Practicing skepticism • Using professional judgment • Maintaining objectivity and integrity • Being professional • Dealing with ambiguity Why Study Auditing? - CORRECT ANSWER One perspective on the role of assurance professionals in financial reporting: Substantively, auditors are centrally implicated in the social production of trust in financial markets. Auditors give comfort to people who are vulnerable to erroneous, self-interested, and possibly fraudulent financial statements from corporate management what is auditing more specifically) of what kind of process it is, what doing and of what, goal, what do once gather - CORRECT ANSWER A systematic process • of objectively obtaining and evaluating evidence • regarding assertions about economic actions and events • to ascertain the degree of correspondence between those assertions • and established criteria • and communicating the results to interested users. What is Attestation? define and 2 - CORRECT ANSWER Attest services occur when a practitioner is engaged to issue a report on subject matter, or an assertion about subject matter, that is the responsibility of another party. • The audit of financial statements is a form of attestation. • Not limited to economic events or actions What is Assurance? - CORRECT ANSWER Independent professional services that improve the quality of information, or its context, for decision makers. • What is meant by quality? • What is meant by context? • The approach, concepts, methods that are used for audits generally apply to other attest and assurance engagements assurance universe see slide - CORRECT ANSWER f/s audits smallest circle, attestation circle aroudn it, assurance circle around that, intersecting with consulting and tax Ideal Auditor Characteristics Who would you want to perform this role if you are the investor? - CORRECT ANSWER knowledge +indepedence ^reflection of their reputation How do we maintain reputation? - CORRECT ANSWER AICPA knowledge thru degree in accounting, cpa exam, experience, cpe AID systems capture details of 3 - CORRECT ANSWER Management, with the guidance of the BOD, decides on OBJECTIVES along with STRATEGIES to achieve those objectives. The organization then undertakes certain PROCESSES in order to implement its strategies. AIS systems capture the details of TRANSACTIONS and designs INTERNAL CONTROLS to ensure transactions are handled, recorded, and REPORTED appropriately. a model of business - CORRECT ANSWER objectives --> strategies --> processes (5 broad categories) on side: transactions, controls, reports A Model of Business Processes: Five Components - CORRECT ANSWER financing process purchasing process human resource management process inventory mgt process revenue process ethics - CORRECT ANSWER Ethics refers to a system or code of conduct based on moral duties and obligations that indicate how we should behave. professionalism - CORRECT ANSWER Professionalism refers to the conduct, aims, or qualities that characterize a profession or professional person. All professions operate under some type of code of ethics or code of conduct. audit ocmittee - CORRECT ANSWER from notes audit ocmmittee is a part of the board of directors - must be only indepedent commite/members What does it mean to be a member of a profession? 5 - CORRECT ANSWER Highly trained • Responsibility to the public • Integrity (Independence) • Code of conduct • Judgment Profession - CORRECT ANSWER An occupation founded upon specialized educational training, the purpose of which is to supply disinterested objective counsel and service to others, for a direct and definite compensation, wholly apart from expectation of other business gain. from notes profession is not an occupation, profession has barriers to entry ie education, certification, training -responsibliity to public ie lawyers, doctors,accountants. must use judgement* What is one difference between the auditing profession and others? - CORRECT ANSWER Regulation auditors insanely regulated compared to other professions Necessary Auditor Characteristics • Let us ask this again . . . • Who would you want to perform this role if you are the investor? - CORRECT ANSWER insider trading ie bw herbalife and sketchers - CORRECT ANSWER Shared information on Herbalife and Skechers • Firm earned $3.9 million in audit fees for 2012 and $3.8 million according to the filing for Herbalife • Firm earned $1.7 million in 2011 for Skechers • Friend gave him $50,000 for the tips (London made $900,000/year) • FBI identified abnormal trading patterns by friend • Friend cooperated by recording conversations with London What happened to KPMG? ie with mr london - CORRECT ANSWER KPMG clients intended to sue KPMG because their information was conveyed by Mr. London to Mr. Shaw. • Return audit fees, amounting to tens of millions of dollars • Liable for other damages if the courts determine that the firm was in any way derelict in monitoring and supervising Mr. London, who was in charge of some 50 audit partners and 500 employees Result with scott london ie prison? - CORRECT ANSWER At 51 years old, Scott London should be at the top of his professional career as the audit partner at the Los Angeles office of Big 4 accounting firm KPMG. • Instead, he had to serve a 14- month federal prison sentence after pleading guilty last year to passing inside information from companies he once audited Why did he do it- Interview in Forbes - CORRECT ANSWER "I knew the rules and followed them for 26 years. I take full responsibility for what I did, but I am at a loss to say exactly why I allowed myself to break my moral and ethical code. I supposed it comes down to other factors in my life," London said. "Between the long tenure of being in the same position in my firm for possibly too long and the desire to help out a friend, those factors may have lead to an impairment of judgment on my part. It is no excuse for sure, but people ask 'why?' and I do my best to answer. what has his life been like for the past year? - CORRECT ANSWER "Worse than I could have ever imagined, which is the message I want to deliver. The consequences to me were tough, but manageable. Dealing with the onslaught of media and the embarrassment of the arrest were the toughest battle of my life. The really hard part was damage to those innocent of my actions; my family, my employer and friends. My family has all been impacted in different ways, but their lives all changed. They are all fine and doing quite well, but things are different for them and they need to do things differently as a result. I think about my employer and the angst I caused them as well as the clients involved. It goes without saying, but I never intended any harm. My friends have also been great, they all have been supportive. Probably the most difficult was the loss of friends and colleagues at my former employer. Aside from the chance meetings in restaurants and such, I have not seen or heard from any of them. I worked there for nearly 30 years and there are some long time relationships that are no longer. That part hurts, but I am moving forward. What is required to provide assurance? - CORRECT ANSWER • Independence + Knowledge • Together, these are a reflection of auditors' reputation • But remember: • The public accounting profession is affected by regulation organizations that affect the accounting profession? 6 - CORRECT ANSWER securities and exchange commission SEC financial accounting standards board FASB international auditing and assurance standards board IAASB public company accounting oversight board PCAOB american institute of certified public accountants AICPA international accounting standards board IASB Other Standards 5 - CORRECT ANSWER Quality Control Standards -Statements on Quality Control Standards (SQCS - by AICPA) Peer Review Standards(Non-Public Clients) AICPA Inspection Standards (Public Clients) PCAOB Compilation and Review Standards Statements on Standards for Accounting and Review Services (SSARS - by AICPA) Attest Engagement Standards Statements on Standards for Attest Engagements (SSAE -by AICPA) Reviews and Agreed-Upon Procedures relevant professional standards for audits of private vs public companies - CORRECT ANSWER private company audit - auditing standards ASB AICPA - GAAS stds professional conduct : AICPA - code of professional conduct . ISB- apply unless AICPA disagrees public company audit auditing standards PCAOB - currently similar to ASB stds with excpetions stds professional conduct : PCAOB - cod eof pressional conduct , SEC-more stringent indepedence rules , ISB- cooperative effort bw aicpa and sec from notes if disclosures are not accurate.... asb gaas what is this pcaob compared to asb sec with independence rules - CORRECT ANSWER if disclosures not accurate, must say so asb = auditing standards board gaas- need to know, kind of like minimum standards and have mulitple interpretations other standards - must know they exist pcaob - similar to asb but a lot more in depth with standards sec has more stringent independence rules for public companies Principles 4 - CORRECT ANSWER • Not enforceable • Hard to know if anyone followed • Intent is to be inspiring • Ideal standards of ethical conduct stated in philosophical terms princples vs rules integrity - CORRECT ANSWER from notes principles as "spirit of the rule" more used to interpret how to act in situations, not enforceable, ideals integrity = the action of honestly (not just telling) Principles define responsibilities public interest integrity objectivity and indepedence due care scope and nature of services - CORRECT ANSWER Principles Some basic tenets of ethical conduct • Responsibilities - should exercise sensitive professional and moral judgment • Public Interest - honor the public trust; professionalism • Integrity - perform responsibilities with the highest sense of integrity • Objectivity and Independence - impartial, unbiased, and independent. Free of conflicts of interest and independent in fact and appearance" • Due care - diligence, competence, thorough, prompt • Scope and nature of services - observe the principles when considering the scope and nature of services provided Rules of Conduct - a lot - CORRECT ANSWER Gradually more specific, are enforceable • Sections involve the fundamentals • Integrity and objectivity • Independence • General standards • Compliance with standards • Accounting principles • Acts discreditable • Contingent fees • Commissions and referral fees • Advertising • Confidential client information • Form of organization and name see slide AICPA code of professional conduct - general to specific w not enforceable vs specifically enforceable vs not specifically enforceable but departures must be justified - CORRECT ANSWER not enforceable - principles of professional conduct- ideal attitudes and behaviors specifcally enforceable - rules of conduct - minimally acceptable standards not specifically but departures must be justified - interpretations of rules of conduct - detailed interpretations and answers to questions regarding rules of conduct over view of AIPA rules of conduct SEE SLIDE!! and handout. do we need to memorize this? - CORRECT ANSWER ie integrity and objectivity indepdence general standards compliance with standards accounting principles acts discredtable contingent fees etc etc AICPA rules of conduct Integrity & Objectivity - CORRECT ANSWER Rule: In the performance of any professional service, a member shall maintain objectivity and integrity, shall be free of conflicts of interest, and shall not knowingly misrepresent facts or subordinate their judgment to others. Interpretation of the rules - CORRECT ANSWER Very specific, like tax Code Section 200: Independence (we'll come back to this) - CORRECT ANSWER 300 - General standards define and 4 - CORRECT ANSWER General Standards Rule (How do they map to the general standards of GAAS?) • A member shall comply with the following standards and with any interpretations thereof by bodies designated by Council. - Professional Competence - Due Professional Care - Planning and Supervision - Sufficient Relevant Data fee, estimated fee, or fee range when it is likely at the time of representation that such fees will be substantially increased and the prospective entity is not advised of that likelihood. • Can't lowball the fee for the first year or so • Making any other representations that would be likely to cause a reasonable person to misunderstand or be deceived. 700 Confidential Client Information Rule define and Five Situations Where CPAs Can Disclose Confidential Information - CORRECT ANSWER Confidential Client Information Rule A member in public practice shall not disclose any confidential client information without the specific consent of the client. Five Situations Where CPAs Can Disclose Confidential Information • To meet GAAP or GAAS disclosure requirements. • As required by an authorized peer review body • To comply with a valid subpoena • As part of an investigative or disciplinary proceeding • In connection with a purchase, sale, or merger of the practice from notes: exceptions ie investigations, sapinas, etc Form of Organization and Name Rule 3 - CORRECT ANSWER -A member may practice public accounting only in a form of organization permitted by law or regulation whose characteristics conform to resolutions of Council. • A member shall not practice public accounting under a firm name that is misleading. Names of one or more past partners may be included in the firm name of a successor organization. • A firm may not designate itself as "Members of the American Institute of Certified Public Accountants" unless all of its CPA owners are members of the Institute. Disciplinary Actions what are the two actions - CORRECT ANSWER The Professional Ethics Executive Committee (PEEC) can direct a member to take remedial or corrective actions. • AICPA Trial Board Actions • Termination of AICPA Membership • Suspend AICPA Membership Quality Control Standards: CPA firms are required to implement a lot - CORRECT ANSWER • Quality of audit maintained • Tone at the top of firm • promoted culture for performing high quality work • Ethical requirements • Personnel management • hire trained ppl and staff appropriately • Client acceptance/continuance • Engagement performance • Monitoring • Peer review / PCAOB inspections look at these QC Let's apply the code... • Which rule(s) of the Professional Code of Conduct did Scott London violate? (see Table 19-2 for help) - CORRECT ANSWER Acts discreditable • Confidential client information • Direct financial interest (Independence) (see p. 643) • Integrity and Objectivity • How about (potentially) Brent Dorsey and colleagues? from notes - CAMS, personnel mgt how long to remediate critcisms? what if don't inspection report issued by who? to who? pt 1 vs pt 2 - CORRECT ANSWER cams - critical audit matters (audit now is required to disclose these) personnel mgt ie if overworking staff audit opinon must say this 12 months to remediate criticsm and say whether entire quality control inspection report issued by pcaob pt 1 to public pt 2 quality control not public if don't remidiate criticisms in 12 months then pt 2 becomes public class 6 - independence skepticism - CORRECT ANSWER So, what is needed for high quality audit? formula for audit quality - CORRECT ANSWER audit quality = f (indepdence, knowledge) What is Independence? • According to the AICPA: 2 if could choose only one... what kind can regulators and firm leaderhsip control - CORRECT ANSWER • Independence in Fact (of Mind) : a state of mind that permits the performance of an attest service without being affected by influences that compromise professional judgment. • Independence in Appearance the avoidance of circumstances that would cause a reasonable and informed third party to reasonably conclude that integrity, objectivity or professional skepticism of the member has been compromised. if could choose one - of fact (of mind) can only control in appearance The SEC's rules are predicated on three basic principles of auditor objectivity and independence: - CORRECT ANSWER 1.An auditor should not audit their own work 2.An auditor should not function in the role of management 3.An auditor should not serve in an advocacy role for the entity Potential Threats to Independence 3 - CORRECT ANSWER Undue Influence: • Attempts by client management to influence your decision making. • Example: threats to terminate the auditor in response to an accounting dispute. Financial Self-Interest: • Benefiting from the financial success of your client. • Example: owning shares in the client. • Management Participation: • Taking on the role of client management. • Example: determining accounting policies for new transactions. from notes: undue influenc e- how can a client attempt to influence decision making? maybe threaten to fire auditor (would do this if feel auditor bad inspction or rate too high etc). auditor could fire client if lots of red flags or feels bullied mgt partiicpation - how could this happen? if auditor takes an adviosry role so supposed to be objective. do not take the role of client mgt SOX Independence Requirements • The following provisions are intended to enhance auditor independence: 4 - CORRECT ANSWER The following provisions are intended to enhance auditor independence: (1)Auditors are prohibited from performing certain non-audit services. (Self-review) (2)Non-audit services to be performed by the auditor must be approved by the audit committee. (Self-review) (3)The lead engagement partner must rotate every five years. (Familiarity) (4)Senior audit team members must wait 1 year before taking an accounting or financial management position with client. (Management participation) from notes - only some tax services are not prohibited for bp 2 Prohibited Financial Relationships 2 supervisors in KPMG's national office that he had taken confidential materials from the PCAOB and revealed, for example, the KPMG audit clients that the PCAOB intended to inspect that year. Allegedly encouraging Sweet to divulge the stolen information to them and others at the firm were his supervisors - David Middendorf, KPMG's then-national managing partner for audit quality and professional practice and Thomas Whittle, KPMG's thennational partner-in-charge for inspections and another highlevel partner at the firm, David Britt, KPMG's banking and capital markets group co-leader Let's apply the code... • Which rule(s) of the Professional Code of Conduct was violated in each of the two KPMG scandals? 4 - CORRECT ANSWER Acts discreditable • Confidential client information • Integrity and objectivity • Independence class 7 - pcaob cont - CORRECT ANSWER Observations indicated in 4010 reports 2 - CORRECT ANSWER 1. Departures from GAAP • Failure to recognize departures from GAAP 2. Auditing deficiencies • Revenues • Accounting estimates • Fair value measurements • Analytical procedures • Income taxes • Allowance for loan losses • Auditing sampling • Use of specialists • Materiality, audit scope and audit differences • Internal control over financial reporting (ICFR) Observations indicated in 4010 reports - 3rd and 4 bp - CORRECT ANSWER 3. Deficiencies in quality control areas • Partner evaluation • Internal inspections • Foreign affiliates • Independence Root Cause Observations - PCAOB weaknesses in 5 - CORRECT ANSWER Weaknesses in... • Training • Audit methodology • Enforcement in policies • Supervision & review • Professional skepticism* *See PCAOB Audit Staff Practice Alert #10 does pcaob name firm that messed up in report - CORRECT ANSWER no refers to them as ie issuesr a/b/c Let's look at a Part II report that became public • https://pcaobus.org/Inspections/Reports/Documents/104- 2016-175-KPMG.pdf • Page 59 and on... • Skepticism - CORRECT ANSWER Professional Judgment define three broad areas changing nature of accounting profession requires... - CORRECT ANSWER The process of reaching a decision or drawing a conclusion where there are a number of possible alternative solutions. • Three broad areas in which professional judgment is often exercised: • (1) Evaluation of evidence • (2) Estimating probabilities • (3) Deciding between options • The changing nature of the accounting profession requires professionals to exercise more professional judgment • Increased use of fair value measurements from notes- reaching a decision where there are a number of possible alternative solutions, invovles subjective analysis when use prof judgement how maintain quesitoning mindset - CORRECT ANSWER utilize hwen selection of relevant evidence, evlaate, estimating proobabilities, deciding bw options ie level three asset ie some innovation that cnanot really value or compare to maintain questioning minset, follow consistent judgement framework (kpmg shines in this aspect) High Quality Professional Judgments • We can enhance auditors' abilities to make high quality judgments through 2 - CORRECT ANSWER • We can enhance auditors' abilities to make high quality judgments through: • Maintaining a questioning mindset (professional skepticism) --> Be wary of mental framing and unconscious biases Following a consistent judgment framework --> Manage external pressures; • Avoid shortcuts and mental traps/wrong triggers (more on this in a couple of days) Professional Skepticism • PCAOB definition: - CORRECT ANSWER PCAOB definition: an attitude that includes a questioning mind and a critical assessment of audit evidence Professional skepticism is an auditor's tendency not to... potential conflict of interest ask...then... - CORRECT ANSWER Professional skepticism is an auditor's tendency not to believe management's assertions without sufficient corroboration. • A potential conflict of interest always exists between the auditor and the client. • Management wants to portray the company and its operations in the best possible light. • Auditors want to portray the company and its operations fairly. • Ask questions, get answers, then verify the answers. • Keep asking until you understand (remember, if you really understand something you should be able to explain it to your younger sibling!) Research on Professional Skepticism - CORRECT ANSWER Research generally shows that auditors do not always take skeptical actions even if they make skeptical judgments Environmental factors affecting judgment external vs internal factors 3 each - CORRECT ANSWER External Factors: • Time pressure • Limited resources • Client, regulatory, industry Internal Factors: • Judgment traps • Judgment shortcuts • Self-interest management incentives in portraying company - CORRECT ANSWER mgt always has incentives to portray ocmpany better (someties even to lessen/worsen how company financials look ie cook jar reserves, lower taxes) **this si why so crucial to keep asking questions young auditors vs partners - CORRECT ANSWER young auditors are smart but not as confident - dont ask as many questions when social mismatch ie when w managers/partners to avoid intiidating interactions if there was a social mismatch in wild/jess case do you think it would have impaired will's skeptisim? Auditor's Role Regarding Fraud - CORRECT ANSWER Auditors design and perform audits to provide reasonable assurance that financial statements are free of material misstatements, whether caused by error or fraud. don't exactly know what reasonable means but is pretty high % - close to 95%- which is usually standard scienttists hold ie with p value can pcaob come after audtiors who fail to uncover fraud? what kind of fraud mgt usually do - CORRECT ANSWER yes because they should be designing procedures that fool proof (unless how regulators proof of following procedures ie due care) -mgt usually financial statemetn fraud continuityX solutions - CORRECT ANSWER The executives of ContinuityX Solutions were charged by the SEC for overstating revenue through the use of fraudulent sales • The SEC's order found that during the audits of ContinuityX, EFP Rotenberg and the accountant, Nicholas Bottini failed to perform sufficient procedures to detect the fraudulent sales in the company's financial statements • Both EFP Rotenberg and Bottini had to pay penalty and were suspended from auditing public companies The Fraud Risk Assessment Process Fraud involves intentional misstatements. The fraud risk identification process includes: Sources of information about possible fraud 4 - CORRECT ANSWER Sources of information about possible fraud― 1.Communications among the audit team 2. Inquires of management and others 3.Analytical procedures 4.Investigation of unexpected period-end adjustments Fraud involves 2 types of intentional misstatements - CORRECT ANSWER fraudulent financial reporting and misappropriation of assets Fraudulent financial reporting includes acts such as the following: 3 - CORRECT ANSWER Manipulation, falsification, or alteration of accounting records or supporting documents used to prepare financial statements. Misrepresentation in, or intentional omission from, the financial statements of events, transactions, or significant information. Intentional misapplication of accounting principles relating to amount, classification, manner of presentation, or disclosure Assessing the Risk of Material Misstatement Due to Error or Fraud misappropriation of assets... 3 examples - CORRECT ANSWER Misappropriation of assets involves the theft of an entity's assets to the extent that financial statements are misstated. examples include: stealing assets paying for goods and services not received by the company embezzling cash received Sue Sachdeva - CORRECT ANSWER Embezzled a total of $34M from Koss corporation to pay for her personal credit card • American Express helped catch her activities. Amex noticed that she was paying for large balances with wire transfers from a Koss account. • Purchases in question included $382,400 at two jewelry stores and $1.4 million at one clothing boutique (much of her clothing and jewelry purchases were never opened or worn) • Sentenced to 11 years in prison, served 6, remains liable for restitution • a future of garnished wages and tax refunds awaits Autonomy - CORRECT ANSWER "It seems from everything I have heard, this vice president of finance had an awful lot of autonomy to do her own thing," • -Tracy Coenen, a fraud examiner and forensic accountant who has been following the case. Internal controls?! -koss - CORRECT ANSWER It's all but impossible to know what the law requires, so it has become a black hole where frightened companies throw endless amounts of money." - Koss on internal controls What do you think led to this fraud?? - CORRECT ANSWER fraud triangle - CORRECT ANSWER incentive/pressure opportunity attitude/rationalization Risk Factors Relating to Incentive/Pressure include: 3 - CORRECT ANSWER Financial stability or profitability is threatened Excessive pressure for management to meet third party expectations Management's personal financial situation is threatened Pressure define and examples - CORRECT ANSWER • Pressure is a "need" felt by the person who commits fraud • Examples • analyst forecasts, smooth income, bonuses • What was Sue's pressure? Risk Factors Relating to Opportunities include: 4 - CORRECT ANSWER nature of the industry/entity's operations ineffective monitoring of management complex/unstable organizational structure deficient internal control Opportunity examples 3 what was sue's opportunity - CORRECT ANSWER • Opportunity is the ability to commit fraud • Examples: • Poor oversight • Information asymmetry • Accounting (complex Transactions • Unusual transactions • Estimates) • What was Sue's opportunity? • Opportunity in the case related to weak internal controls and lack of management oversight by Michael Koss and company Risk Factors Relating to Attitudes/Rationalizations include: 6 - CORRECT ANSWER Nonfinancial management's excessive participation in selection of accounting principles and estimates Excessive interest by management in stock prices and earning trends Committing to aggressive or unrealistic forecasts Ineffective communication of ethical standards or selection of inappropriate ethical standards if yr end 12/31 audit opinions may come out 2-3 months after for accelerated filers Responsibility: Evaluate reasonableness of reserve (Case 4.5) 3 AU 316 requries auditors to perform... - CORRECT ANSWER • Review and test the process used by management to develop the reserve • Develop an independent expectation of the reserve • Review subsequent events or transactions completed prior to the end of fieldwork AU 316 requires auditors to perform a retrospective review of actual expenses incurred related to reserve accounts to evaluate whether management judgments and assumptions are reasonable. What is a retrospective review? SEC Enforcement Action - Reserves D. Fraudulent Manipulation of Reserves and Other Income how did xerox do this - CORRECT ANSWER • 58. Xerox also pumped up its earnings by nearly $500 million through the release into income of excess or "cushion" reserves originally established for some other purpose. Xerox's use of these reserves violated GAAP and its intentional or reckless use of reserves for this purpose without disclosure was fraudulent 59. FAS 5, "Accounting for Contingencies," The systematic or timed release of excess reserves into income violates GAAP... with xerox - CORRECT ANSWER 59. FAS 5, "Accounting for Contingencies," allows a company to establish reserves for identifiable, probable and estimable risks and precludes the use of reserves for general or unknown business risks, including excess reserves, because they do not meet the accrual requirements of FAS 5. Any reserves that do not meet the accrual requirements of FAS 5, when identified, should be immediately released into income. • The systematic or timed release of excess reserves into income violates GAAP. From 1997 through 2000, Xerox knowingly or recklessly violated GAAP by repeatedly manipulating the release of approximately $496 million of reserves to close the gap between actual results and earnings targets; this amount includes the effects of improperly timed reserve releases of $78 million which affected only interim periods within a fiscal year. Failing to disclose the reserve releases caused Xerox's financial reports to be materially false and misleading audit risk - from notes formula - CORRECT ANSWER risk of giving incorrect audit opinion- want to ahcieve audit risk lwo ie 5% so reasonable assurance 95% audit risk AR=IR inherent risk (industry/client risk) * CR (control risk -risk material misstatement and controls fail to detect) * DR (detection risk - aduit procedures fail to detect) • Reasonable assurance relate to risk likelihood of problems 5 - CORRECT ANSWER Reasonable assurance implies there is some risk that a material misstatement could be present and the auditor fails to detect it • Plan audit to achieve low audit risk • More work, less risk • Likelihood of problems • Inherent Risk • Control Risk • Detection Risk • Audit Risk • Together create the audit risk model To respond appropriately to financial statement level risks, the auditor may do the following: 3 - CORRECT ANSWER Assign more experienced personnel or those with specialized knowledge. Evaluate the selection and application of accounting policies to identify earnings management or bias that may create a material misstatement. Incorporate additional elements of unpredictability in the selection of audit procedures. Evaluation of Audit Test Results At the completion of the audit, the auditor should consider: 1 then If the financial statements are materially misstated, the auditor should 2 - CORRECT ANSWER At the completion of the audit, the auditor should consider: 1. Whether the total misstatements cause the financial statements to be materially misstated. THEN ... If the financial statements are materially misstated, the auditor should: 1. Request management to eliminate the material misstatement, or 2. If management does not make needed adjustments, the auditor should issue a qualified or adverse opinion. Management Assertions 2 and notes - CORRECT ANSWER • Alleged facts stated explicitly or implicitly in or through accounting disclosures (including numbers) in the financial statements • Book definition: Expressed or implied representations in the financial statements regarding recognition, measurement, presentation, and disclosure from notes assertion is a cliam mgt assertions are about the four finanical satemetns and footnotes, stated explicitely ie footnotes, implicitely ie implied, disclosures . 2 types of views of mg assertions - pcaob and aicpa but we will focus on pcaob in this class Management Assertions: PCAOB 5 - CORRECT ANSWER -Existence/Occurrence - Completeness -Valuation/Allocation -Rights/Obligations -Presentation and Disclosure from notes: existsence ie cash mgt said was there is actually there completeness ie no cash was left out valuation /allocaiton - amounts in fin statements properly valued/allocated. are ie level 1/2/3 property vallues, ie AR stated at NRV rights/oblications - are assets actually the rights of entity or someone else? presentation - are amounts property represented, incorrect categories disclosed etc aicpa cutoff- if rev cutoff 12/15 for 12/31 yr end is this actually correct revenues? - CORRECT ANSWER pcaob definitions observation confirmation inquiry - CORRECT ANSWER observation - observe client as go through procedures confirmation - questions to outside parties ie customers, suppliers banks inquiry - relates to mgt - inquires of mgt if any fraud, whether mgt owns all the assets pcaob definitions cont scanning reperformance/recalculation - CORRECT ANSWER scanning - briefly look for anomolies (not same thinga as inspection) reperfromance/recalculation - auditor may reperfrom things the client performs risky for different accounts • E.g. Existence is not that risky for liabilities (for profit maximizing companies) • More focus is placed on more risky assertions • Identify RELEVANT ASSERTIONS (AS 5, 28) The Concepts of Audit Evidence 3 - CORRECT ANSWER -nature (form or type) -sufficiency and appropriateness -evaluation Nature of Audit Evidence 8 - CORRECT ANSWER Records of initial entries and supporting records invoices contracts worksheets adj to fin statements GL and SL spreadsheets supporting cost allocations other computations reconciliations and disclosures Sufficiency of Audit Evidence define sufficiency in relation and 2 - CORRECT ANSWER Sufficiency is the measure of the quantity of audit evidence. Greater risk of misstatement requires a higher quantity of audit evidence. Higher quality audit evidence results in a lower quantity of audit evidence. Appropriateness of Audit Evidence 2 and 5 - CORRECT ANSWER Appropriateness is a measure of the quality of audit evidence. invoices 2: relevance and reliability 5:Independent source outside the entity Effectiveness of internal control Auditor's direct personal knowledge Documentary evidence Original documents Proper evaluation of evidence requires an understanding of the:2 an auditor should be thorough in searching for evidence and ____ in its evaluation - CORRECT ANSWER 1.Types of evidence available 2.Relative reliability of available evidence. unbiased Audit Procedures are and: 3 Categories - CORRECT ANSWER Specific acts performed by the auditor to gather evidence about whether specific assertions are being met. 1. risk assessmment procedures 2. test of controls 3. substantive procedures Audit Procedures define - CORRECT ANSWER A set of audit procedures prepared to test assertions for a component of the financial statements is referred to as an audit program. example of existance vs rights and obligations vs completeness vs valuation - CORRECT ANSWER confirm AR = existence rights and obl=Inquire of management whether receivables have been sold. completeness = Agree total of accounts receivable subsidiary ledger to accounts receivable control account. valuation= Test the adequacy of the allowance for doubtful accounts Inspection of records and documents how does the specific assertion impact the test?2 - CORRECT ANSWER Evidence obtained from external documents is more reliable than evidence obtained from internal documents. What would you use as the population to sample from if you were performing a tests of details on AR for existence? • What would you use as the population to sample from if you were performing a tests of details on AR for completeness? two types of inspecton records and documents - CORRECT ANSWER vouching (occurence) tracing (completeness) Inspection of tangible assets - CORRECT ANSWER Physical examination of a tangible asset (e.g., go look at a sample of fixed asset additions). Observation - CORRECT ANSWER The process of watching a process or procedure being performed by others.... (e.g., ughh...the dreaded "inventory observation") Inquiry auditor should 6 - CORRECT ANSWER Consider the knowledge, objectivity, experience, responsibility, and qualifications of the individual to be questioned. • Ask clear, concise, and relevant questions. • Use open or closed questions appropriately. • Listen actively and effectively. • Consider the reactions and responses and ask follow-up questions. • Evaluate the response. confirmation the reliability of evidence obtained through conf may be impacted by 4 - CORRECT ANSWER The process of obtaining a representation of information or of an existing condition directly from a third party The reliability of evidence obtained through external confirmations may be affected by factors such as: • The form of the confirmation (positive vs. negative). • Prior experience with the entity. • The nature of the information being confirmed. • The intended respondent. confrimation note: - CORRECT ANSWER Note: Some audit evidence counts as more than one procedure. For example, confirmations of AR would involve the audit procedures of "Inspection of documents" and "Confirmation" Information Frequently Confirmed by Auditors- source of conf? she enjoys aromatherapy and attending a local spirituality group. • Is Sarah more likely to be a school teacher or a holistic healer? • What is a "base-rate probability"? Anchoring and Adjustment Heuristic - CORRECT ANSWER • Insufficiently adjusting away from an initial anchor • Example: •The sticker price on a new car • What are some anchors that might trip up an auditor? Halo Effect - CORRECT ANSWER • Basing assessments of specific individual attributes on their overall assessment of a person or thing • Example: Grade A student assumed to be more morally responsible than a Grade C student dilution effect - CORRECT ANSWER The perceived importance of relevant information is diminished by the presence of irrelevant information • Example: Doctor trying to diagnose pneumonia •X-ray of lungs •Low grade Fever •Hair color overocnfidence self-serving bias confirmation bias - CORRECT ANSWER Overconfidence • Unwarranted confidence in one's ability to make a decision • Self-Serving Biases • The tendency to make judgment and decisions that are consistent with one's self-interest • Confirmation bias • Gathering and overweighting (underweighting) evidence that confirms (disconfirms) one's beliefs judgement traps - CORRECT ANSWER Rush to solve Solving the wrong problem Judgment triggers class notes 2/18 - CORRECT ANSWER management assertions- explicit? two assertions not discussed in class - CORRECT ANSWER do not have to be explicit, could be implicit cutoff and accuracy (similar to valuaiton0 inspection of documents observation example - CORRECT ANSWER inspection of documents ie source documents, lead schedules (first level of breakdown for a big account) obseration ie looking at what client is doing --> how reliable is observation? less reliable because people know you're watching them perferformance ie confirmation vs inquiry - CORRECT ANSWER perfromance is more reliabile bc doing it yourself inquiry- to client - doesn't have to me oral- could also be written is cash or equipment stolen risker? appropriateness tracing vs vouching - CORRECT ANSWER cash more evidence--> better assruance appropraiteness=level of quality so worry about if is relevant and reliable if go from source document --> JL is tracing- confirmation if go from JL--> source = vouching - existence footing - checking the totals analytical procedures sbstantive analytical procedures important - CORRECT ANSWER analytical procedures- try to find a pattern - assess reasonableness of data (not exactness) ie "does this make sense" ie looking at financial ratios if substantive analytical procdures weren't required - still do it bc very good evidence and ives you ideas on where to ask questions **is not precise evidence** bias hw - CORRECT ANSWER 1. conf bias 2. overconfidence 3. anchoring 4. availability