Audit Exam #2

Front 1

Internal control

Back 1

A processed designed to provide reasonable assurance regarding the achievement of management's objectives in the following categories: 1) reliability of financial reporting, 2) effectiveness and efficiency of operations, & 3) compliance w/ applicable laws & regulations.

Front 2

Limitations of internal control

Back 2

1) Personnel errors
2) Management override
3) Collusion
4) Cost-benefit tradeoff

Front 3

Section 404(a) of the Sarbanes-Oxley Act requires management of all public companies to issue an internal control report that includes the following:

Back 3

1) A statement that management is responsible for establishing & maintaining an adequate internal control structure & procedures for financial reporting
2) An assessment of the effectiveness of the internal control structure and procedures for financial reporting as of the end of the company's fiscal year

Front 4

Management's assessment of internal control over financial reporting consists of two key aspects:

Back 4

1) Management must evaluate the design of internal control over financial reporting
2) Management must test the operating effectiveness of those controls

Front 5

Transaction-related audit objectives:

Back 5

1) Occurrence--recorded transactions exist
2) Completeness--existing transactions are recorded
3) Accuracy--recorded transactions are stated at the correct amounts
4) Posting & summarization--recorded transactions are correctly included in the master files & are correctly sumarized
5) Classification--transactions are correctly classified
6) Timing--transactions are recorded on the correct dates

Front 6

Auditor responsibilities for understanding internal control

Back 6

1) For all clients, auditors must understand the IC system well enough to plan & perform the audit
2) For large public clients, auditors must audit the IC system & issue audit opinion about the effectiveness of ICs

Front 7

What controls must be tested in an audit of internal controls?

Back 7

Internal Controls over Financial Reporting

Front 8

What controls must be tested in an audit of financial statements?

Back 8

Internal Controls used to Assess Control Risk below Maximum

Front 9

5 Components of Internal Control (COSO)

Back 9

1) Control environment
2) Risk assessment
3) Control activities
4) Information & communication
5) Monitoring

Front 10

Collusion

Back 10

A cooperative effort among employees to steal assets or misstate records

Front 11

Control environment

Back 11

The actions, policies, & procedures that reflect the overall attitudes of top management, directors, & owners of an entity about internal control & its importance to the entity

Front 12

Risk assessment

Back 12

Management's identification & analysis of risks relevant to the preparation of financial statements in accordance w/ an applicable accounting framework

Front 13

Control activities

Back 13

Policies & procedure, in addition to those included in the other four components of internal control, that help to ensure that necessary actions are taken to address risks in the achievement of the entity's objectives.

Front 14

Five specific control activities:

Back 14

1) Adequate separation of duties
2) Proper authorization of transactions & activities
3) Adequate documents & records
4) Physical control over assets & records
5) Independent checks on performance

Front 15

Information & communication

Back 15

The set of manual and/or computerized procedures that initiates, records, processes, & reports an entity's transactions & maintains accountability for the related assets

Front 16

Monitoring

Back 16

Management's ongoing & periodic assessment of the quality of internal control performance to determine that controls are operating as intended & are modified when needed

Front 17

T/F: The auditor must issue an adverse opinion if there's even one material weakness?

Back 17

TRUE!!

Front 18

Control subcomponents:

Back 18

1) Integrity & ethical values
2) Commitment to competence
3) BOD or audit committee participation
4) Management's philosophy & operating style
5) Organizational structure
6) Human resource policies & practices

Front 19

Separation of duties:

Back 19

1) Separation of the custody of assets from accounting
2) Separation of the authorization of transactions from the custody of related assets
3) Separation of operational responsibility from record-keeping responsibility
4) Separation of IT duties from user departments

Front 20

To understand the design of the accounting information system, the auditor determines . . .

Back 20

1) The major classes of transactions of the entity
2) How those transactions are initiated & recorded
3) What accounting records exist & their nature
4) How the system captures other events that are significant to the financial statements
5) The nature & details of the financial reporting process followed, including procedures to enter transactions & adjustments in the general ledger.

Front 21

Risk assessment processes:

Back 21

1) Identify factors affecting risks
2) Assess significance of risks & likelihood of occurrence
3) Determine actions necessary to manage risks

Front 22

Categories of management assertions that must be satisfied:

Back 22

1) Assertions about classes of transactions & other events
2) Assertions about account balances
3) Assertions about presentation & disclosure

Front 23

Process for understanding internal control & assessing control risk:

Back 23

1) Obtain & document understanding of internal control design & operation
2) Assess control risk
3) Design, perform, & evaluate tests of controls
4) Decide planned detection risk & substantive tests

Front 24

Three commonly used methods of document the understanding of internal controls:

Back 24

1) Narratives
2) Flowcharts
3) Internal control questionnaires

Front 25

Internal control questionnaire

Back 25

A series of questions about the controls in each audit area used as a means of indicating to the auditor aspects of internal control that may be inadequate

Front 26

The goal of assessing control risk is to determine whether IC design . . .

Back 26

1) Will prevent misstatements from occurring?
2) Will detect & correct misstatements that have occurred?

Front 27

We assess control risk for . . .

Back 27

each transaction-related audit objective for each major transaction in each cycle.

Front 28

Process of assessing control risk:

Back 28

1) Identify audit objectives
2) Identify existing controls
3) Associate controls w/ related audit objectives
4) Identify & evaluate control deficiencies, significant deficiencies, & material weaknesses.

Front 29

Control deficiency

Back 29

A deficiency in the design or operation of controls that does not permit company personnel to prevent or detect misstatements on a timely basis.

Front 30

Significant deficiency

Back 30

One or more control deficiencies exist that is less severe than a material weakness, but important enough to merit attention by those responsible for oversight of the company's financial reporting.

Front 31

Material weakness

Back 31

A significant deficiency in internal control that, by itself, or in combination with other significant deficiencies, results in a reasonable possibility that a material misstatement of the financial statements will not be prevented or detected.

Front 32

The goal of testing controls is . . .

Back 32

to determine whether controls are operating effectively.

Front 33

Procedures to support the operating effectiveness of internal controls:

Back 33

1) Perform a walkthrough
2) Make inquiries of appropriate client personnel
3) Examine documents, records, & reports
4) Observe control-related activities
5) Reperform client procedures

Front 34

Walkthrough

Back 34

The tracing of selected transactions through the accounting system to determine that controls are in place.

Front 35

If the assessed level of control risk equals the planned control risk, . . .

Back 35

no change to substantive tests is necessary.

Front 36

If the assessed level of control risk is greater than the planned control risk, . . .

Back 36

then must increase substantive tests.

Front 37

Outline of the audit process:

Back 37

1) Review client background information
2) Perform preliminary analytical procedures
3) Obtain an understanding of the ICS
4) Perform preliminary audit planning (i.e., assess materiality, set AR, & consider the mix of tests)
5) Test controls & perform substantive TOT
6) Revised plan based on test of controls, if needed
7) Test ending balances
8) Render opinion

Front 38

Types of audit tests

Back 38

1) Risk assessment procedures
2) Tests of controls
3) Substantive tests of transactions
4) Analytical procedures
5) Tests of details of balances

Front 39

Procedures to obtain an understanding of internal control

Back 39

Procedures used by the auditor to gather evidence about the design & implementation of specific controls; used to create preliminary assessment of CR for each transaction-related objective.

Front 40

Substantive tests of transactions

Back 40

Audit procedures testing for monetary misstatements to determine whether the six transaction-related audit objectives have been satisfied for each class of transactions.

Front 41

Tests of controls

Back 41

Audit procedures to test the effectiveness of controls in support of a reduced assessed control risk.

Front 42

Test of details of balances

Back 42

Audit procedures testing for monetary misstatements to determine whether the eight balance-related audit objectives have been satisfied for each significant account balance.

Front 43

Main procedures to obtain an understanding of IC:

Back 43

1) Evaluate prior experience w/ client
2) Inquiry
3) Read policies & manuals
4) Examine documents & records
5) Observe activities & operations

Front 44

T/F: Exceptions discovered during TOCs indicate a FS misstatement?

Back 44

FALSE!! (not necessarily)

Front 45

Primary procedures for STOT:

Back 45

1) Reperformance
2) Documentation

Front 46

Analytical procedures

Back 46

Use of comparisons & relationships to assess whether account balances or other data appear reasonable.

Front 47

Two of the most important purposes of analytical procedures in the audit of account balances are to:

Back 47

1) Indicate possible misstatements in the financial statements.
2) Provide substantive evidence.

Front 48

T/F: Tests of details of balances can be done on B/S or I/S accounts.

Back 48

TRUE!!

Front 49

8 balance-related objectives:

Back 49

1) Existence
2) Completeness
3) Accuracy
4) Classification
5) Cutoff
6) Detail tie-in
7) Realizable value
8) Rights & obligations

Front 50

Can tests of details of balances be eliminated?

Back 50

NO!! Substantive tests of transactions can't help us w/ realizable value rights & obligations, or presentation/disclosure.

Front 51

Revenues are . . .

Back 51

inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivery of producing goods, rendering services, or other activities that constitute the entity's major or central operation.

Front 52

Reveue is recognized when ________ & ______.

Back 52

realized, earned

Front 53

Realization

Back 53

Product/service is exchange for cash, promise to pay, or other asset that's convertible to cash

Front 54

Earned

Back 54

Entity has substantially completed the earnings process (generally upon delivery of product or service provided).

Front 55

When is revenue recognized?

Back 55

WHEN SHIPPED!! (title transfers at shipping point)

Front 56

Side agreements

Back 56

Arrangements used to alter terms & conditions of recorded sales in order to entice customers to accept delivery of goods (EX: Netopia).

Front 57

Channel stuffing

Back 57

Inducements to distributors to buy substantially more inventory than they can promptly sell (EX: Coca-Cola).

Front 58

Bill & hold

Back 58

Inducements for customers to issue PO's in advance of needing goods; seller agrees to ship goods at later date (EX: Diebold).

Front 59

Five classes of transactions in the sales & collections cycle:

Back 59

1) Sales (cash & sales on account)
2) Cash receipts
3) Sales returns & allowances
4) Write-off of uncollectible accounts
5) Estimate of bad debt expense

Front 60

Major functions of revenue process

Back 60

1) Order entry: acceptance of customer orders & entry into system in accordance w/ management criteria
2) Credit authorization: appropriate approval of customer orders for credit worthiness
3) Shipping: shipping of goods that have been authorized
4) Billing: issuance of sales invoice to customers for goods shipped/services provided; processing of billing adjustments for allowances, discounts, & returns.

Front 61

Major functions of cash receipts process

Back 61

1) Cash receipts: processing of receipt of cash from customers
2) Accounts receivable: recording all sales invoices, collections, & credit memoranda in individual customer accounts
3) General ledger: proper accumulation, classification, & summarization of revenues, collections, & receivables in the F/S accounts

Front 62

Key separation of duties:

Back 62

1) Credit funciton needs to be separate from sales (separation of authorization from custody)
2) Shipping function needs to be separate from billing (separation of custody from accounting)
3) Cash receipts need to be separate from A/R (separation of custody from accounting)

Front 63

Lapping of accounts receivable

Back 63

The postponement of entries for the collection of receivables to conceal an existing cash shortage.

Front 64

Three key authorizations:

Back 64

1) Credit must be properly authorized before a sale takes place.
2) Goods should be shipped only after proper authorization.
3) Prices, including basic terms, freight, & discounts, must be authorized.

Front 65

Key controls:

Back 65

1) Adequate documents & records (EX: duplicate copies retained as evidence)
2) Prenumbered documents & accounting for series--reduces chance of not billing or double billing
3) Monthly statements--encourages error reporting by customer for which they aren't given credit for their full amount

Front 66

Sales invoices exist but not bills of lading (existence/occurrence)

Back 66

Start w/ a sample of sales invoices recorded in the sales journal & agree to BOL.

Front 67

Bills of lading exist but not sales invoices (completeness)

Back 67

Start w/ a sample of bills of lading & agree to sales invoices.

Front 68

What steps are typically involved in a sales transaction?

Back 68

1) Take customer order --> prepare sales order
2) Credit is approved --> approved sales order
3) Release goods from inventory & ship them --> BOL
4) Bill customer --> sales invoice & sales summary
5) Record the sale --> Updated A/R & sales in subledger & GL

Front 69

Sales summary

Back 69

This is a computer-generated file that includes all sales transactions processed by the accounting system for a period, which could be a day, week, or month. It includes all information entered into the system & information for each transaction, such as customer name, date, amount, account classification(s), salesperson, & commission rate.

Front 70

What controls are considered important? All sales are approved by the credit department.

Back 70

1) For a sample of sales invoices recorded in the sales journal, we're going to trace to sales order & check for authorization by the credit department.
2) Inquire & observe the credit dept. authorizing sales.

Front 71

What controls are considered important? All shipments are authorized.

Back 71

Inquire & observe shipping dept. checking for authorization before shipment.

Front 72

What controls are considered important? Prices are authorized.

Back 72

1) Examine authorized price list.
2) For a sample of sales invoices recorded in the sales journal, compare price billed to approved price.

Front 73

What controls are considered important? Prenumbered sales orders, BOL, & sales invoices are used & the series is accounted for periodically.

Back 73

1) Examine prenumbered documents.
2) Inquire & observe about the accounting for the series.

Front 74

What controls are considered important? Monthly statements are sent to customers.

Back 74

1) Examine the correspondence files related to the monthly statements.
2) Inquire & observe the appropriate person mailing & preparing the monthly statements.

Front 75

What controls are considered important? Independent verification of the quantities on invoice.

Back 75

For a sample of invoices recorded in the sales journal, compare quantity shipped & ordered to the quantity billed.

Front 76

What controls are considered important? Independent verification of the mathematical accuracy of the invoice.

Back 76

For a sample of invoices recorded in the sales journal, recalculate the invoice.

Front 77

What controls are considered important? Standard chart of accounts is used.

Back 77

1) Examine the chart of accounts.
2) For a sample of invoices recorded in the sales journal, compare accounts used w/ the standard chart of accounts.

Front 78

What steps are typically involved in a collections transaction?

Back 78

1) We receive cash receipt --> immediately restrictively endorse AND prepare prelisting/list of receipts
2) Prepare deposit slip --> deposit cash each day
3) Update cash receipts journal & A/R records

Front 79

Prelisting of cash receipts

Back 79

This is a list prepared when cash is received by someone who has no responsibility for recording sales, A/R, or cash, and who has no access to accounting records. It is used to verify whether cash received was recorded & deposited at the correct amounts and on a timely basis.

Front 80

What controls are considered important? Mail is opened by people outside of the accounting department.

Back 80

1) Inquire & observe mailroom personnel to determine if they have any incompatible duties (recording duties).

Front 81

What controls are considered important? Checks are immediatey restrictively endorsed.

Back 81

Inquire & observe the mailroom personnel restrictively endorsing the checks.

Front 82

What controls are considered important? Cash receipts are prelisted/summarized.

Back 82

1) Inquire & observe mailroom personnel prepare the prelisting/summary.
2) For a sample of cash receipts recorded in the cash receipts journal, trace back to prelisting.

Front 83

What controls are considered important? Cash is deposited daily in the bank.

Back 83

1) Inquire & observe cash receipts personnel preparing the deposit slip & deposit the checks.
2) Compare the validated deposit slips (date & amt) to the cash summary.

Front 84

What controls are considered important? The appropriate personnel reconciles the bank statement (no custody or recording responsibilities).

Back 84

1) Inquire & observe the person preparing the bank reconciliation (proper person, done on a timely basis--i.e., every month).
2) Examine a sample of the monthly bank reconciliations.
3) Reperform a bank rec.

Front 85

Sampling

Back 85

To apply an audit procedure to less than 100% of the items making up an account balance.

Front 86

Attributes sampling:

Back 86

A statistical, probablistic method of sample evaluation that results in an estimate of the proportion of items in a population containing a characteristic or attribute of interest.

Front 87

Sampling of balances:

Back 87

used to estimate AMOUNT of misstatement present in account balance.

Front 88

Representative sample

Back 88

A sample w/ characteristics the same as those of the population.

Front 89

Risks involved in sampling:

Back 89

1) Sampling risk
2) Non-sampling risk

Front 90

Sampling risk

Back 90

Risk of reaching an incorrect conclusion inherent in tests of less than the entire population because the sample is not representative of the population.

Front 91

How can sampling risk be reduced?

Back 91

By using an increased sample size & an appropriate method of selecting sample items from the population.

Front 92

Non-sampling risk

Back 92

The risk that the auditor fails to identify existing exceptions in the sample; nonsampling risk is caused by failure to recognize exceptions and by inappropriate or ineffective audit procedures.

Front 93

To minimize non-sampling risk:

Back 93

1) Design good tests
2) Use experienced auditors
3) Avoid boredom & exhaustion

Front 94

Statistical sampling

Back 94

The use of mathematical measurement techniques to calculate formal statistical results & quantify sampling risk. Requires random sample.

Front 95

Nonstatistical (judgemental) sampling

Back 95

The auditor's use of professional judgement to select sample items, estimate the population values, & estimate sampling risk.

Front 96

Steps in sampling:

Back 96

1) Plan the sample
2) Select the sample & perform the tests
3) Evaluate the results

Front 97

Plan the sample:

Back 97

1) State the objectives of the audit test.
2) Decide whether audit sampling applies.
3) Define attributes & exception conditions.
4) Define the population.
5) Define the sampling unit.
6) Specify the tolerable exception rate.
7) Specify acceptable risk of assessing control risk too low.
8) Estimate the population exception rate.
9) Determine the initial sample size.

Front 98

Evaluate the results:

Back 98

1) Generalize from the sample to the population.
2) Analyze exceptions.
3) Decide the acceptability of the population.

Front 99

Nonprobabilistic (judgemental) sample selection methods:

Back 99

1) Directed sample selection
2) Block sample selection
3) Haphazard sample selection

Front 100

Probabilistic sample selection methods:

Back 100

1) Simple random sample selection
2) Systematic sample selection
3) Probability proportional to size sample selection
4) Stratified sample selection

Front 101

Directed sample selection

Back 101

A nonprobabilistic method of sample selection in which each item in the sample is selected based on some judgmental criteria established by the auditor (EX: larger accounts or those more likely to contain errors).

Front 102

Block sample selection

Back 102

A nonprobabilistic method of sample selection in which items are selected in measured sequences.

Front 103

Haphazard sample selection

Back 103

A nonprobabilistic method of sample selection in which items are chosen without regard to their size, source, or other distinguishing characteristics.

Front 104

Random sample

Back 104

A sample in which every possible combination of elements in the population has an equal chance of constituting the sample.

Front 105

Systematic sample selection

Back 105

A probabilistic method of sampling in which the auditor calculates an interval (the population size divided by the number of sample items desired) & selects the items for the sample based on the size of the interval & a randomly selected starting point between zero & the length of the interval.

Front 106

Probability proportional to size

Back 106

Each DOLLAR has an equal chance of being included in the sample.

Front 107

Stratified sample selection

Back 107

Separate population into subpopulations based on size & choose samples for each subpopulation/strata.

Front 108

Characteristics of interest in attribute sampling:

Back 108

1) Control deviation rate (for tests of controls)
2) Monetary misstatements in transactions (for substantive tests of transactions)

Front 109

Attribute sampling is used to . . .

Back 109

1) Estimate proportion of a population containing a certain characteristic.
2) Evaluate whether controls are working well enough to support the initial control risk assessment or transactions are being recorded correctly enough.

Front 110

Tolerable Exception Rate (TER)

Back 110

The exception rate that the auditor will permit in the population & still be willing to conclude the control is operating effectively and/or the amount of monetary misstatements in the transactions established during planning is acceptable.

Front 111

The TER is a . . . & depends on . . .

Back 111

matter of auditor judgment, assessed materiality & importance of attribute

Front 112

EX: If we need a control to work 96% of the time, what is the TER?

Back 112

4%

Front 113

Big materiality --> ____ TER & high importance --> ___ TER

Back 113

high, low

Front 114

The _____ the TER, the _______ the sample.

Back 114

lower, smaller

Front 115

Acceptable risk of assessing control risk too low (ARACR)

Back 115

The risk that the auditor is willing to take of accepting a control as effective or a rate of monetary misstatements as tolerable when the true population exception rate is greater than the tolerable exception rate.

Front 116

The ARACAR is a . . . & depends on . . .

Back 116

auditor judgment, assessed CR

Front 117

Estimated population exception rate (EPER)

Back 117

Exception rate the auditor expects to find in the population before testing begins (based on work done in the prior year or information from management)

Front 118

Sample exception rate (SER)

Back 118

Number of exceptions in the sample divided by the sample size

Front 119

Computed upper excepted rate (CUER)

Back 119

The upper limit of the probable population exception rate; the highest exception rate in the population at a given ARACR.

Front 120

CUER =

Back 120

SER + allowance for sampling error

Front 121

T/F: Larger samples are more precise.

Back 121

TRUE!!

Front 122

Higher ARO allows more risk so _______ sample.

Back 122

smaller

Front 123

Bigger difference between TER & EPER requires less precision so _______ sample.

Back 123

smaller

Front 124

The worst we expect the population to perform, the ______ the sample size.

Back 124

larger

Front 125

If TER is greater than or equal to the CUER:

Back 125

Control works well enough to rely on it ("Risk is less than ARO that control fails more than TER")

Front 126

If TER is less than CUER:

Back 126

Control's not working well enough ("Risk is more than ARO that control fails more than TER").

Front 127

T/F: When the sample results don't seem to support the assessed CR, you revise TER or ARO.

Back 127

FALSE!! These are set before results are known.

Front 128

What do you do when the sample results don't seem to support assessed CR?

Back 128

1) Expand sample (costly)
2) Revise CR & add more substantive testing