Auditing Quiz 1

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Sarbanes-Oxley Public Company Accounting Reform and Investor Protection Act

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passed in July 2002 to restore investor confidence after a number of high-profile accounting frauds

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Conflict of interest

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the goals of managers and owners may not coincide

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Information risk

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the risk that information circulated by a company’s management will be false or misleading, which auditor’s aim to reduce

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Unqualified audit report

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because the financial statements are free of material misstatements, the auditor does not find it necessary to qualify his or her opinion about the fairness of the financial statements

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The objective of auditing

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to determine whether management’s assertions are fair

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Auditing

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a process of obtaining and evaluating evidence regarding assertions about economic events for the purpose of communicating the correspondence between the assertions and established criteria

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Attest services

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an assertion could be about anything for which there is an established criterion, not necessarily economic events

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Assurance services

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independent professional services that improve the quality of information, or its context, for decision makers

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Relationship between auditing, attest services, and assurance services

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Auditing is a type of attest service
Attest services is a type of assurance service

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3 Major Concepts of the Audit Process

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1. Materiality
2. Audit risk
3. Audit evidence regarding management assertions

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Materiality

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is the amount of misstatement that would probably have made a difference in the judgment of a reasonable user who is relying on that information

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Rule of thumb for materiality

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total misstatements of more than about 3-5 percent of income before tax would cause the financial statements to be materially misstated

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Audit risk

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the risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated

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Audit evidence consists of:

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underlying accounting data and any additional information available to the auditor, whether originating from the client or externally, and are evaluated by the auditor before they arrive at an opinion

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Audit evidence must be:

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Gathered objectively (in an unbiased matter)
Sufficient to support the audit opinion
Competent, both relevant and reliable

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Auditors collect evidence in these three stages:

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1. The internal control put in place by the client to ensure proper handling of transactions
2. The transaction that affect each account balance
3. The ending account balances themselves

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Major phases of an audit

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Client acceptance/continuance
Preliminary engagement activities
Plan the audit
Consider and audit internal control
Audit business procedures and related accounts
Complete the audit
Evaluate results and issue audit reports

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Preliminary engagement activities

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1. Determine the audit engagement team requirements
2. Ensure the independence of the audit team and audit firm
3. Establish an understanding with the client regarding the services to be performed

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Types of audits

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Financial statement
Compliance
Operational
Forensic
Tax

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Financial statement auditor

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independent auditor; audit opinion issued

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Compliance auditor

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internal auditor/CPA; regulatory report or internal report on extent to which entity complies with rules, policies, laws, etc.

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Operational auditor

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internal audit; report to management or audit committee regarding the efficient and effective use of resources

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Forensic auditor

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purpose is to detect or deter fraud

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Tax auditor

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IRS auditor

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Auditing standards of private companies are called __ and established by __

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GAAS
Auditing Standards Board (ASB)

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Auditing Standards Board (ASB)

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a part of AICPA, a national professional organization that CPAs may choose to join
they establish auditing standards

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Auditing standards of public companies (SEC issuers) are established by:

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Public Company Accounting Oversight Board (PCAOB)
Their standards replaced ASB's since the Sarbanes-Oxley act

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Relationship between ASB, PCAOB, and IAASB (International Auditing and Assurance Standards Board)

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In 2012, the ASB converged their standards with the IAASB, but the PCAOB has not converged

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10 PCAOB standards

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establish a minimum required level of quality for performing financial statement audits for public companies

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PCAOB standards acronym

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General standards (TIP)
Field work (SIE/PIE)
Reporting (WACI)

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General PCAOB standard 1

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The audit has to be performed by a person or persons having adequate technical TRAINING and proficiency as an auditor

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General PCAOB standard 2

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In all matters relating to the assignment, an INDEPENDENCE in mental attitude is to be maintained by the auditor(s)

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General PCAOB standard 3

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Due PROFESSIONAL care is to be exercise in the performance of the audit and the preparation of the report

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Field work PCAOB standard 1

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The work is to be adequately PLANNED and assistants, if any, are to be properly SUPERVISED

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Field work PCAOB standard 2

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A sufficient understanding of INTERNAL CONTROL is to be obtained to plan the audit and determine the nature, timing, and extent of tests to be performed

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Field work PCAOB standard 3

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SUFFICIENT, COMPETENT, and EVIDENTIAL MATTER is to be obtained to afford a reasonable basis for an opinion regarding the financial statements under audit

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Reporting PCAOB standard 1

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The reporter shall express an OPINION regarding the financial statements, taken as a WHOLE, or an assertion to the effect that an opinion cannot be expressed

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Reporting PCAOB standard 2

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The report shall state whether the financial statements are presented in ACCORDANCE WITH GAAP

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Reporting PCAOB standard 3

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The report shall identify the circumstances in which current practices are not CONSISTENT with the preceding period

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Reporting PCAOB standard 4

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INFORMATIVE DISCLOSURES in the financial statements are to be regarded as reasonably adequate unless otherwise stated in the report

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ASB and IAASB Clarity Standards four groups:

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1. Purpose and premise of an audit
2. Auditor’s responsibilities
3. Auditor’s actions in performing the audit
4. Reporting

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An independent audit aids in the communication of economic data because the audit
a. Confirms the exact accuracy of management’s financial representations
b. Lends credibility to the financial statements
c. Guarantees that financial data are fairly presented
d. Assures the readers of financial statements that any fraudulent activity has been corrected

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b. Lends credibility to the financial statements

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14. Which of the following best describes the reason why an independent auditor is often retained to report on financial statements?
a. Management fraud may exist, and it is more likely to be detected by independent auditors than by internal auditors
b. Different interest may exist between the entity preparing the statements and the persons using the statements, and thus outside assurance is needed to enhance the credibility of the statements
c. A Misstatement of account balances may exist, and all misstatements are generally corrected as a result of the independent auditor’s work
d. An entity may have a poorly designed internal control system

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b. Different interest may exist between the entity preparing the statements and the persons using the statements, and thus outside assurance is needed to enhance the credibility of the statements

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15. Which of the following best describes relationships among auditing, attest, and assurance services?
a. Attest is a type of auditing service
b. Auditing and attest services represent two distinctly different types of services – there is no overlap
c. Auditing is a type of assurance service
d. Assurance is a type of attest service

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c. Auditing is a type of assurance service

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17. For what primary purpose does the auditor obtain an understanding of the entity and its environment?
a. To determine the audit fee
b. To decide which facts about the entity to include in the audit report
c. To plan the audit and determine the nature, timing, and extent of audit procedures to be performed
d. To limit audit risk to an appropriately high level

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c. To plan the audit and determine the nature, timing, and extent of audit procedures to be performed

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21. Which of the following statements best describe what is meant by an unqualified audit opinion?
a. Issuance of an unqualified auditor’s report indicates that in the auditor’s opinion the client’s financial statements are not fairly enough presented in accordance with agreed-upon criteria to qualify for a clean opinion
b. Issuance of an unqualified auditor’s report indicates the auditor is not qualified to express an opinion that the client’s financial statements are fairly presented in accordance with agreed-upon criteria
c. Issuance of an unqualified auditor’s report indicates the auditor is expressing different opinions on each of the basic financial regarding whether the client’s financial statements are fairly presented in accordance with agreed-upon criteria
d. Issuance of a standard unqualified auditor’s report indicates that in the auditor’s opinion the client’s financial statements are fairly presented in accordance with agreed-upon criteria, with no need for the inclusion of qualifying phrases

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d. Issuance of a standard unqualified auditor’s report indicates that in the auditor’s opinion the client’s financial statements are fairly presented in accordance with agreed-upon criteria, with no need for the inclusion of qualifying phrases

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15. Which of the following is not a part of the role of internal auditors?
a. Assisting the external auditors
b. Providing reports on the reliability of financial statements to investors
c. Consulting activities
d. Operational audits

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b. Providing reports on the reliability of financial statements to investors

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16. Operational auditing is oriented primarily toward
a. Future improvements to accomplish the goals of management
b. The accuracy of data reflected in management’s financial records
c. Verification that an entity’s financial statements are fairly presented
d. Past protection provided by existing internal control

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a. Future improvements to accomplish the goals of management

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19. Which of the following statements best describes management’s and the external auditor’s respective levels of responsibility for a public company’s financial statements?
a. Management and the external auditor share equal responsibility for the fairness of the entity’s financial statements in accordance with GAAP
b. Neither management nor the external auditor has significant responsibility for the fairness of the entity’s financial statements in accordance with GAAP
c. Management has the primary responsibility to ensure that the company’s financial statements are prepared in accordance with GAAP, and the auditor provides reasonable assurance that the statements are free of material misstatements
d. Management has the primary responsibility to ensure that the company’s financial statements are prepared in accordance with GAAP, and the auditor provides a guarantee that the statements are free of material misstatement

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c. Management has the primary responsibility to ensure that the company’s financial statements are prepared in accordance with GAAP, and the auditor provides reasonable assurance that the statements are free of material misstatements

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21. The Public Accounting Oversight Board
a. Is a quasi-governmental organization that has legal authority to set auditing standards for audits of public companies
b. Is a quasi-governmental organization that has legal authority to set accounting standards for public companies
c. Is a quasi-governmental organization that has a policy to ignore public comment and input in the process of setting auditing standards
d. Is a quasi-governmental organization that is independent of the SEC in setting auditing standards

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a. Is a quasi-governmental organization that has legal authority to set auditing standards for audits of public companies

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23. Which of the following best describes the general character of the three generally accepted auditing standards classified as standards of field work?
a. The competence, independence, and professional care of persons performing the audit
b. Criteria for the content of the auditor’s report on financial statements and related footnote disclosures
c. Criteria for audit planning and evidence gathering
d. The need to maintain an independence of mental attitude in all matters relating to the audit

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c. Criteria for audit planning and evidence gathering

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Who set the Code of Conduct and who must follow it?

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Set by the AICPA (a private non-governmental association)
All practicing CPAs must follow it even if they are not a member of the AICPA

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Code of Conduct

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The code covers all services CPAs provide, including consulting and tax services
GAAS and PCAOB standards define the quality of an audit only

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Code of conduct principles

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General, not really enforceable
Outline highest level of service CPA is expected to perform

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Code of conduct rules

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Detailed, enforceable, explicit rules
Outline minimum level of service CPA is expected to perform

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Code of conduct section 100 rules

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Relates to the character of the CPA

Rule 101: Independence
Rule 102: Objectivity and Integrity

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Code of conduct section 200 rules:

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Makes pronouncements of the AICPA binding

Rule 201: General standards, like GAAS, but apply to all services a CPA performs, not just audits
Rule 202 and 203: Violating standards of GAAP automatically violates rules of conduct

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Code of conduct section 300 rules:

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Deals with relations with clients

Rule 301: Confidentiality (information is not privileged)
Rule 302: Contingent fees (based on time this is OK)

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Code of conduct section 400 rules:

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Repealed in the 1970s so they no longer exist

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Code of conduct section 500 rules:

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Other responsibilities and practices
Does not allow the CPA to commit discreditable acts, falsely advertise, work for commission, etc.

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Phases during which materiality is considered

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Materiality is considered during the planning phase, the audit conducting phase, and the result evaluation phase

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Materiality thresholds are determined for

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the balance sheet and income statement, both individual items and aggregate level

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Qualitative thresholds to keep in mind

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High fraud risk
Control weaknesses
First-year engagement
Higher than normal risk of bankruptcy
Needing to attain important benchmarks

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A (small/large) materiality estimate will result in (more/less) evidence

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small = more
large = less

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Relationship between risk, materiality, and evidence

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Higher risk = Lower materiality threshold = more audit work = better types of audit evidence

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How to handle immaterial intentional errors

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considered material even if the amount is not large (because there is an increased risk of other material misstatements)

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The auditor might have to turn down a client who is:

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lacking integrity or financially unstable

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3 pre-planning activities

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1. Determine the audit team requirements
Size complexity, risk, expertise, personnel availability, and timing
2. Assess the firm’s and team’s independence
3. Establish an understanding with the client

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engagement letter

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document terms of the audit and minimize misunderstandings
includes client and auditor responsibilities and fees

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Steps of engagement planning

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1. Gain an understanding of the company and assess risks
2. Establish materiality
3. Assess the possibility of illegal acts
4. Identify related parties
5. Conduct preliminary risk assessment procedures

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Fraud

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individual(s) within the client organization acting against the client organization

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Illegal act

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an intentional violation of law by the client organization

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Auditor's responsibility regarding illegal acts

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The auditor has a responsibility to provide reasonable assurance of detection of illegal acts that have a direct effect on the financial statements, but no assurance for those that have indirect effects

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Related party transactions

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if one party controls or can significantly influence the management or operation policies of the other

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Identify related parties by reviewing:

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Board minutes
Conflict-of-interest statements.
Transactions with major customers, suppliers, borrowers, and lenders.
Large, unusual, or nonrecurring transactions especially at year end.
Loan agreements for guarantees

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Section 301 of SOC Act overview

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The requirements for audit committee members of public companies

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Section 301 of SOC Act requirements

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Audit committee members requirements:
• Member of board of directors & independent.
• Directly responsible for overseeing work of any registered public accounting firm employed by the company.
• Must preapprove all audit and nonaudit services provided by its auditors.
• Must establish procedures to follow for complaints.
• Must have authority to engage independent counsel.

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Types of audit tests

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Risk assessment procedures
Test of controls
Substantive procedures

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Risk assessment procedures

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used to obtain an understanding of the entity and its environment, including internal controls

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Test of controls purpose

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directed towards the evaluation of the effectiveness of the design and implementation of internal controls

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Test of controls methods

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Inquiry
Inspection
Observation
Walk through
Reperformance

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Substantive procedures

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detect material misstatements in a transaction class, account balance, and disclosure component of the financial statements

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Dual purpose test

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performing test of controls along with substantive procedures

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Analytical procedures

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evaluating financial information by analyzing the relationships among financial and non-financial data

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Internal auditors must be

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objective and competent and have a systematic and disciplined approach