Audit Part 3

Front 1

Auditor's are responsible for:

Back 1

obtaining reasonable assurance that the financial statements as a whole are free from material misstatement whether caused by fraud or error

Front 2

primary responsibility for fraud prevention tests:

Back 2

rest with company management

Front 3

auditing standards require the audit team to discuss the susceptibility of the financial statements to fraud:

Back 3

-a discussion of management's involvement in supervising employees with access to cash or other assets
-consideration of unusual/unexplained changes in behavior of employees
-consideration of types of circumstances that indicate possibility of fraud
-discussion of how an element of unpredictability can be built into audit procedures
-discussion of any allegations of fraud

Front 4

fraud triangle

Back 4

rationalization, opportunity, pressure

Front 5

pressure

Back 5

when company management feels pressure from the inside/outside the company to meeting earnings targets

Front 6

opportunity

Back 6

when an individual believes that internal controls are weak or not designed to prevent fraud and can be overridden

Front 7

rationalization

Back 7

when an individual believes that their actions to commit fraud can be justified

Front 8

errors vs. fraud

Back 8

error: unintentional acts of the company

fraud: intentional acts of the company

Front 9

two types of fraud

Back 9

fraudulent financial reporting - occurs when a company prepares financial statements that are materially misstated

assets are missappropriated - employees in company steal its assets

Front 10

detecting financial statement fraud

Back 10

1) management and board
2) relationship with others
3) organization & industry
4) financial results & operating characteristics

Front 11

What are the accounts involved, and fraud schemes?

Transaction: estimate all uncollectible accounts receivable

Back 11

accounts involved: bad debt expense, allowance for doubtful accounts

fraud schemes: understate allowance for doubtful accounts, thus overstating receivables

Front 12

What are the accounts involved, and fraud schemes?

sell goods/services to customers

Back 12

accounts involved: accounts receivable, revenues

fraud schemes: record fictitious sales, recognize revenues too early, overstate real sales

Front 13

What are the accounts involved, and fraud schemes?

accept returned goods from customers

Back 13

accounts involved: sales returns, accounts receivable

fraud schemes: not record returned goods from customers, record returned goods after the end of the period

Front 14

What are the accounts involved, and fraud schemes?

write off receivables as uncollectible

Back 14

accounts involved: allowance for doubtful accounts, accounts receivable

fraud schemes: not write off uncollectible receivables, write off uncollectible receivables in a later period

Front 15

What are the accounts involved, and fraud schemes?

collect cash after discount period

Back 15

accounts involved: cash, accounts receivable

fraud schemes: record bank transfers as cash received from customers, manipulate cash received from related parties

Front 16

What are the accounts involved, and fraud schemes?

collect cash within discount period

Back 16

accounts involved: cash, sales discount, accounts receivable

fraud schemes: not recognize discounts given to customers

Front 17

What are the accounts involved, and fraud schemes?

purchase inventory

Back 17

accounts involved: inventory, accounts payable

fraud schemes: under-record purchase, record purchases too late, not record purchases

Front 18

What are the accounts involved, and fraud schemes?

return merchandise to supplier

Back 18

accounts involved: accounts payable, inventory

fraud schemes: overstate returns, record returns in an earlier period

Front 19

What are the accounts involved, and fraud schemes?

pay vendor within discount period

Back 19

accounts involved: accounts payable, inventory, cash

fraud schemes: overstate discounts, not reduce inventory cost

Front 20

What are the accounts involved, and fraud schemes?

inventory is sold; cost of goods sold is recognized

Back 20

accounts involved: cost of goods sold, inventory

fraud schemes: record at too low an amount, not record cost of goods sold nor reduce inventory

Front 21

What are the accounts involved, and fraud schemes?

inventory becomes obsolete

Back 21

accounts involved: loss in write-down of inventory

fraud schemes: not write off or write down obsolete inventory

Front 22

What are the accounts involved, and fraud schemes?

inventory quantity are estimated

Back 22

accounts involved: inventory shrinkage, inventory

fraud schemes: over-estimate inventory

Front 23

What are the accounts involved, and fraud schemes?

inventory quantities are counted

Back 23

accounts involved: inventory shrinkage, inventory

fraud schemes: over-count inventory

Front 24

What are the accounts involved, and fraud schemes?

inventory cost is determined

Back 24

accounts involved: inventory, cost of goods sold

fraud schemes: incorrect costs used, incorrect extensions are made, record fictitious inventory

Front 25

professional skepticism

Back 25

the auditor is expected to conduct the audit with an attitude of professional skepticism when considering a company's risk of fraud.

-an attitude or state of mind
-involves having a questioning mind, making a critical assessment of evidence, especially the reliability of the evidence gathered

Front 26

6 characteristics of skepticism

Back 26

1) questioning mind - sense of doubt
2) suspension of judgment - withholding judgment until evidence is obtained
3) search for knowledge - desire to investigate beyond obvious
4) interpersonal understanding - recognition that people's motivations and perceptions can lead them to provide biased information
5) autonomy - self-direction, moral independence, and conviction to decide for oneself
6) self-esteem - self confidence to resist persuasion and to challenge assumptions

Front 27

types of auditor tools - data analysis

Back 27

1) build a profile of potential frauds, obtain data, verify, cleanse, and analysis data

2) regression analysis - idea of finding relationships in large data pools

3) calculate ratio of maximum to minimum - verify accuracy of product prices, areas where large variations are not expected

4) analyze transactions during non-business hours and weekends

Front 28

Risk of fraud can be mitigated, but not ____.

Back 28

completely eliminated - due to limitations of effectiveness of controls and possibility to override such controls

Front 29

Types of fraud controls

Back 29

1) process controls such as reconciliations and physical count. They identify anomalies in accounting entries,
identify anomalies in accounting entries. They also review areas of activity susceptible to manipulation (accounting estimates)

2) whistleblower program

Front 30

the auditor's assessment of fraud determines the nature, extent, and timing of audit. If the risk of fraud is high, the auditor can:

Back 30

1) change the nature of audit testing and obtain more reliable evidence
2) change the timing of audit tests and perform substantive tests at year end
3) change the extent of audit tests and gather more audit evidence

Front 31

reporting of fraud to management and the audit committee:

Back 31

the auditor needs to bring the fraud to the attention of the appropriate level of management, usually one level above where the fraud occurred. Fraud involving management (that materially misstates financial statements) should be reported to the audit committee

Front 32

PCAOB auditing standards require the external auditor to communicate various matters to the audit committee, including, but not limited to, the following:

Back 32

1) accounting policies, management judgments, accounting estimates
2) auditor's judgment
3) significant differences
4) uncorrected misstatements that were determined by management to be immaterial
5) audit adjustments
6) significant internal control deficiencies or material weaknesses

Front 33

the auditor is required to document in their workpapers their understanding of:

Back 33

1) significant decisions made during the audit team's discussion regarding the susceptibility of the company's financial statements to material misstatement because of fraud
2) how and when fraud discussion occurred
3) the identified and assessed risks of material misstatements due to fraud at financial statement level and relevant assertion level (as well as procedure performed to obtain the information)

Front 34

The auditor is required to document in the work papers their response to:

Back 34

1) The assessed risk of material misstatement due to fraud at the financial statement level and at the assertion level; and a linkage between the audit procedures and the assessed risk of material misstatement

2) The results of the audit procedures including those designed to address the risk of management override of internal controls

3) Other conditions and analytical procedures that cause the auditor to believe that additional auditing procedures were appropriate to address the risk of material misstatement because of fraud

Front 35

Knowledge Acquisition: Sales Process: Activities

Back 35

1) Marketing -> Customer Approval -> Sales Order Entry -> Shipping Delivery -> Pricing/Billing

2) Service Order Entry -> Service Delivery -> Pricing/Billing

3) Pricing/Billing -> Collection, Sales Adjustments, Account Write-off

Front 36

Accounts in the Sales Process

Back 36

Balance Sheet Accounts: Accounts Receivable, Allowance for Doubtful Accounts

Income Statement Accounts: Sales, Sales Return and Allowances, Sales Discounts, Bad Debt Expense

Front 37

Revenue assertions:

Back 37

Do recorded sales actually exist?
Are all existing sales transactions recorded?
Are sales recorded on the correct dates?
Are sales properly authorized?
Are sales properly valued?
Are sales properly classified?
Are sales transactions properly included in the master file and correctly summarized?

Front 38

Relevant Assertions: Accounts Receivable

Back 38

Do recorded receivables exist?
Are all existing receivables recorded?
Are receivables recorded on correct dates?
Is the right to collect on receivables present?
Does aged trial balance of receivables agree to customer accounts and tie in with general ledger?
Are receivables properly valued (i.e. stated at realizable value)?
Are receivables are properly classified?

Front 39

Evidence from risk assessment analysis:

Back 39

extensive evidence from risk assessment analysis:
test of controls - observation and inquiry
test of controls - documentation and reperformance
analytical review - analytical procedures of performance indicators

substantive testing:
sample based test of high risk assertions
test of accounting estimates
tests of disclosures

Front 40

how does an auditor design tests of controls for revenue or sales?

Back 40

1) understand internal control as it relates to sales
2) assess the planned control risk related to sales
3) control testing decision
4) design tests of controls for sales

Front 41

1) understand internal control as it relates to sales

Back 41

considerations: management controls, general controls (access controls, other software related controls); documents understanding of internal controls for sales

Front 42

key control procedures for revenue process

Back 42

1) segregation of duties
2) authorization procedures
3) documented transaction trails

Front 43

segregation of duties

Back 43

different employees should:
-initiate sales transaction, approve credit, ship goods, prepare sales invoice, collect cash payments, write off accounts

Front 44

authorization procedures

Back 44

sales contracts are approved by management, credit sales approved by the credit department, goods are then shipped, prices used come from a price list, uncollectible accounts are written off, sales return and allowances are authorized and classified

Front 45

documented transaction trails

Back 45

-bills for shipping documents exist for all sales invoices
-approved customer sales orders support each sales invoice
-sales recorded as revenue are supported by invoice
-invoices are prenumbered and accounted for
-allowance for uncollectible accounts is reviewed on a timely basis

Front 46

2) assess the planned control risk related to sales

Back 46

-document control strengths and weaknesses
-identify key internal controls that might be used for testing
-think about compensating controls
-determine if the key controls are designed effectively

Front 47

3) control testing decision

Back 47

-can he/she reduce risk of material misstatement to a sufficiently low level via only substantive tests?

-assumption is that it will be rare that substantive tests alone will reduce risk, especially in revenue

Front 48

4) design tests of controls for sales

Back 48

the auditor considers:
-dual-purpose tests: combined test of control effectiveness and substantive test of transactions

-tests for all management assertions for which key controls exist

-direction of tests (omitted vs. nonexistent transactions)

Front 49

examples of analytical procedures:

Back 49

1) compare previous years/industry data at a detailed level:
-receivables turnover and days outstanding
-aging categories on aged trial balance
-bad-debt expense as a percentage of revenue
-allowance for uncollectible accounts as a percentage of accounts receivable or credit sales

Front 50

primary assertions for sales and accounts receivable:

Back 50

Tests of sales transactions: primarily existence and cuttoff.

Tests of accounts receivables: Primarily existence (through confirmation) and valuation

Front 51

examples of substantive tests of sales transactions:

Back 51

-Trace customer to approved customer list and compare to approved credit limits.
-Compare quantities per sales order, shipping document and invoice.
-Trace price to appropriate master price list.
-Recompute extensions and footing of invoice.
-Test accuracy of customer record in the subsidiary ledger.
-Vouch subsequent payment of invoice including validity of discounts taken and interest charged (if any).

Front 52

Professional standards require the confirmation of receivables unless:

Back 52

both apply -
1) risk of material misstatement is low
2) use of confirmations would be ineffective

Front 53

Effectiveness of A/R confirmation:

Back 53

1) discovers fictitious accounts and incorrect amounts
2) discovers uncollectibles

Front 54

What does A/R confirmation not do?

Back 54

discovering omitted accounts (assertion: completion)

Front 55

A/R confirmation decisions:

Back 55

Negative confirmation - request a response only if the customer believes that the amount printed on the confirmation is incorrect

Positive confirmation - request that the customer respond whether or not the balance is correct

Blank confirmation - Ask the customer to indicate the amount owed at a certain date

Front 56

Which confirmation decisions are most reliable?

Back 56

positive responses are considered the most reliable evidence

-negative responses are returned only if recipient disagrees but could also mean they did not get, read, or care

Front 57

aged trial balance

Back 57

the basis for many substantive tests of A/R and the allowance for uncollectible accounts

Front 58

audit of aged trial balance

Back 58

need to perform tests to ensure aging is accurate:
1) assess reasonableness of uncollectible percentages based on historical percentage of write-offs and aging category

2) increasing percentage of accounts receivable as they are older should be considered doubtful of collectability

3) aged trial balance is often starting point for selection of receivables to confirm. Confirm most, if not all, accounts over 60 days. Use sampling for the rest

Front 59

alternative substantive procedures to determine existence, accuracy, valuation (A/R)

Back 59

examine:

cash receipts, bank accounts, etc.
shipping documentation
sales invoice
client correspondence

Front 60

Why sample?

Back 60

because it is impossible to review 100% of the controls/transactions applied during the year.

Front 61

representative sample

Back 61

has the same characteristics as the population from which the sample was taken.

Front 62

audit risk =

Back 62

Sampling risk + Nonsampling risk (aspects of audit risk not related to sampling)

Front 63

Sampling risk

Back 63

the risk that the sample is not representative of the population; for tests of controls, includes the risk of assessing control risk too high (which affects the efficiency of the audit); and the risk of assessing control risk too low (which affects the effectiveness of the audit)

Front 64

nonstatistical sampling:

Back 64

Judgmentally determine sample size, implicitly recognizing relevant factors.

Judgementally select a representative sample

Apply audit procedures

Evaluate test results judgmentally

Front 65

statistical sampling

Back 65

Determine sample size EXPLICITLY

randomly select a representative sample

apply audit procedures

evaluate test results statistically using judgment

Front 66

controlling sampling risk:

Back 66

Statistical sampling: auditor can quantify sampling risk. Allows for auditor to keep it an acceptable number

nonstatistical sampling: selecting appropriate sampling sizes (risk decreases as size increases), correctly evaluating sample results to consider sample risk

Front 67

attribute sampling

Back 67

the auditor determines whether a characteristic of interest (attribute) in the population (the internal control) is present by looking at a sample from the population.

Ex: test of sales invoice to ensure credit has been authorized

Front 68

attribute

Back 68

tested control or transaction

Front 69

deviation or error

Back 69

an exception from the tested characteristic or a mistake in a transaction

Front 70

Tolerable deviation rate (TDR)

Back 70

the deviation or mistake rate the auditor will permit and still be willing to conclude the process control is operating effectively.

Front 71

Tests of Controls Sampling Plan

Back 71

Step 1 Describe the internal control being tested
Step 2 Determine the control objectives including the relevant assertion
Step 3 Define the population and the sampling unit
Step 4 Define the deviation condition
Step 5 Determine the desired level of assurance, the tolerable deviation rate, and the expected population deviation rate
Step 6 Select method for determining sample size
Step 7 Determine the method of sample selection
Step 8 List the selected sample items
Step 9 Describe how the sampling procedure was performed
Step 10 Evaluate the sample results and make a decision

Front 72

test objective

Back 72

to determine whether the control is present, for example, a signature from management as required authorization or approval

Front 73

sampling unit

Back 73

usually a document (invoice, purchase order) or journal entry

Front 74

deviation condition

Back 74

occurs when there is no indication that the control has been performed.

this gives the auditor a clear understanding of the conditions necessary for the control to be working.

Front 75

As the desired level of assurance increases:

Back 75

sample size increases: The higher the auditor’s desired level of assurance that the results of the sample are representative of the population, the larger the sample size needs to be

Front 76

As the tolerable rate of deviation increases:

Back 76

sample size decreases: The lower the tolerable rate of deviation, the larger the sample size needs to be

Front 77

As the expected rate of deviation increases:

Back 77

sample size increases: The higher the expected rate of deviation, the larger the sample size needs to be so that the auditor can make an accurate estimate of the actual rate of deviation

Front 78

As population increases:

Back 78

it is negligible to the sample size: For large populations (>500) , the size of the population has little or no effect on sample size

Front 79

When is the method of determining the sample size (statistical/nonstatistical) determined?

Back 79

after the auditor has specified the Tolerable Deviation Rate, the Expected Rate of Deviation, and the Desired Level of Assurance

Front 80

methods of sample selection:

Back 80

simple random sampling, systematic random sampling, haphazard sampling

Front 81

simple random sampling

Back 81

the auditor generates random numbers from a random number table or a computer program and then selects the document number corresponding to the random number generated. (Appropriate for statistical and nonstatistical sampling)

Front 82

Systematic Random Sampling

Back 82

the auditor divides the number of units in the population by the number in the sample size to calculate a sampling interval and then generates a random number in the sampling interval. The random number is the first item chosen, and the following items are determined by adding the sampling interval to the random number. Appropriate for statistical and nonstatistical sampling.

Front 83

Haphazard Sampling

Back 83

the auditor selects the sample without any conscious bias. May be used when the items in the population are not prenumbered documents. Cannot be used for statistical sampling

Front 84

If the internal control test is a dual-purpose test:

Back 84

the auditor examines the item to determine whether it contains a deviation from the documented control and then the auditor reperforms the control.

Front 85

Evaluating results of Tests of controls:

Back 85

Is the control working?

Yes: Actual Control deviation + allowance for sampling risk < tolerable deviations (substantive testing would be reduced)

No: actual control deviation + allowance for sampling risk > tolerable deviations (increase substantive testing, consider it as a material weakness or significant deficiency)

Front 86

variables sampling

Back 86

The use of sampling to test account balances and classes of transactions (substantive testing)

Front 87

As assessment of inherent risk increases:

Back 87

Sample size increases

Front 88

As Assessment of control risk increases

Back 88

Sample size increases

Front 89

As assessment of risk related to other substantive procedures related to the same assertion increases

Back 89

Sample size increases

Front 90

As tolerable misstatement increases

Back 90

Sample size decreases

Front 91

As expected misstatement or the variance of the population increases

Back 91

Sample size increases

Front 92

What is a contingent liability?

Back 92

A potential future obligation to an outside party for an unknown amount resulting from activities that have already taken place.

Front 93

what are the relevant GAAP recommendations? (contingent liabiity)

Back 93

Likely and reasonably estimated - accrual
Likely and not estimable - footnote disclosure
Not determinable - footnote disclosure
Unlikely - no financial statement or disclosure unless significant adverse effect

Front 94

The auditor should ask the client to prepare a letter (client letterhead, signed by client officer) asking the attorney to respond directly to the auditor concerning:

Back 94

-client’s description of the nature & current status of all outstanding & possible claims with which the attorney has been involved
-client’s evaluation of the amount & likelihood of loss or gain for each listed outstanding & possible claim
-any unlisted or potential items, or whether the status of each claim or assessment is described appropriately

Front 95

Subsequent events

Back 95

are events or transactions having a material effect on the financial statements that occur after the balance sheet date but before field work completion.

Front 96

Events that provide additional evidence about conditions that existed at the balance sheet date (e.g., settlement of liabilities, realization of assets)

vs.

Events that occur after the balance sheet date and do not relate to conditions that existed at year-end

Back 96

Client financial statements for the period under audit must be adjusted to reflect this subsequent event information.

These subsequent events must be disclosed in the footnotes of the period under audit. The auditor may also consider whether client should prepare
pro forma financial statements.

Front 97

What about a subsequent event that occurs after field work completion?

Back 97

Options:
1. Expand all subsequent events tests to the date of the event and change the report date to the date of the event (e.g., 2/21)

2. Restrict testing only to matters relating to the new event and dual-date the report:

Front 98

Events Subsequent to Audit Report

Back 98

Auditors have no obligation to perform additional procedures after the report date unless they become aware of facts that existed at the report date

Front 99

The auditor is not responsible for preventing noncompliance with all laws and regulations. (T/F)

Back 99

true (the auditor should perform audit procedures to identify noncompliance that could have a material impact on the financial statements)

Front 100

Three-Step Evaluation of Going Concern

Back 100

1) Consider evidence that indicates that a going-concern problem may exist.

2) Evaluate management’s plan to mitigate the identified conditions.

3) Determine if management's plan is adequate and appropriate for the circumstances, and assess the likelihood that the company will suffer financial distress.

Front 101

Signs of Financial Distress

Back 101

Asset composition:
Existence of underperforming assets

Debt levels:
Lack of new sources of debt financing

Cost structure:
Negative cash flows

Equity position:
Inability to obtain additional equity financing

Front 102

Mitigating Circumstances

Back 102

-Disposal of extraneous assets.
-Restructuring of financing.
-Acquisition of new financing.
-Reduction or deferral of expenditures.

Front 103

The auditor must obtain a letter from the client documenting the client’s representations during the engagement:

Back 103

The primary purposes are to:
- Confirm and document oral statements.
- Reduce auditor-client misunderstanding.
- Remind management of responsibilities.

The letter should be signed by the client CFO and CEO and dated with the field work completion date.