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Audit Risk, Materiality, and Audit Evidence - Be able todefine audit risk and explain why we cannot eliminate it; describe therelationships between audit risk, materiality, and audit evidence; explain (ingeneral terms) what materiality is, who sets it, and how they set it.




audit risk, and why we can not eliminate it

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




can't eliminate because its to expensive





materiality


who sets it? and how they set it

information is material if omitting it or misstating it could influence decisions that users make on the basis of the financial information of a specific reporting entity.




decided by auditor, judgment call

audit evidence

evidence that assist the auditor in evaluating management's financial statement assertions consists of the underlying accounting data and any additional information available to the auditor, whether originating from the client or externally




-should be sufficient and appropriate


-relevant- is the information related to the specific assertion being tested?


-reliable- can the information be relied upon to signal the true state of the specific assertion

Auditing Standards – What is the purpose of auditingstandards? How do auditing standards differ from auditing procedures? What organization promulgates auditingstandards for audits of public companies? What organization promulgatesstandards for audits of private companies?



standards

what you are supposed to achieve, auditing standards serve as guidelines for and measures of the quality of the auditor's performance


-these standards help ensure the quality of auditors performance


-auditing standards vs auditing procedures


---procedures= how you implement standards

what organization promulgates auditing standards for adults of purloin companies/ privates companies

-PCAOB sets for public


-AICPA sets for private companies

Illegal acts – types (direct/indirect, material/immaterial).What assurance does the auditor provide?




-direct immaterial-no assurance


-direct material- reasonable assurance


-indirect- no assurance

Tests of controls, substantive tests, and dual-purpose tests– definitions.



test of controls

directed toward the evaluation of the effectiveness of the design and operation of internal controls



substantive

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

dual purpose test

combination of both test described above

Materiality – definition in the auditing context.

-materiality- a substantial likelihood that the fact would have significantly altered the total mix of info made available




-steps in applying materiality to the audit


1.determine overall materiality


2. determine tolerable misstatement


3. evaluate audit findings

The Audit Risk Model(ARM) – know the equation, what the abbreviations mean, be able to define thedifferent types of risk, and know how they relate to one another (i.e., if CRgoes up, DR goes ???).



the equation

AR= IR X CR X DR

know what the abbreviations mean


AR

-AR= audit risk





IR

inherent risk


-the likelihood that in the absence of internal controls, an error or fraud will enter the accounting information system

CR

control risk


-the likelihood that an error or fraud will not get caught by the client's internal controls

DR

deduction risk


-risk that the auditor will not detect misstatement

IR X CR

risk of material misstatement

extra info

qualitative terms are generally used as opposed to quantitative

Assessing the risk of material misstatement due to error orfraud – definitions of the types of misstatements. What assurance does theauditor provide for detecting material and immaterial frauds and errors?



factual misstatements

misstatements about which there is no doubt

judgemental misstatements

misstatements that arise from differences between the auditors judgments concerning accounting estimates and managements estimates that the auditor considers unreasonable or inappropriate

projected misstatements

auditors best estimate of misstatements in populations, involving the projection of misstatements identified in an audit sample to the entire population which the sample was drawn

immaterial errors or fraud

-no assurance


-reasonable assurance if material

Required fraud riskassessment procedures? Which specific risks must be included in the auditor’sassessment of fraud risk?

-discussion among the audit team


-inquires of management and others


-risks- management over ride of control (This was highlighted)

Management assertions –memorize the specific assertions and understand the definition of each. Be ableto identify the assertion that is most likely violated given a brief scenario.



assertions about classes of transactions and events for the period under audit

-occurrence- transactions and events that have been recorded have occurred and pertain to the entity ( sometimes referred to as validity)




-completeness- all transactions and events that should have been recorded have been recorded




-authorization- all transactions and events have been properly authorized




-accuracy- amounts and other data relating to recorded transactions and events have been recorded appropriately




-cutoff- transactions and events have been recorded in the correct accounting period




- classification- transactions and events have been recorded in the proper accounts

assertions about account balances at the period end

-existence- assets, liabilities, and equity interest exists




-rights and obligations- the entity holds or controls the rights to assets, and liabilities, are the obligations of the entity




-completeness- all assets, liabilities, and equity interests that should have been recorded have been recorded




-valuation and allocation- assets, liabilities, and equity interests are included in the financial statements at appropriate amounts, and any resulting valuation or allocation adjustments are appropriately recorded

assertions about presentation and disclosure

-occurrence and rights and obligations- disclosed events, transactions, and other matters have occurred and pertain to the entity




-completeness- all disclosures that should have been included in the financial statements have been included




- classification and understandability- financial information is appropriately presented and described, and disclosures are clearly expressed




-accuracy and valuation- financial and other information is disclosed fairly and in appropriate amounts



What stages of the audit require the performance ofanalytical procedures?

testing- final review



Tracing and vouching –what do these terms mean? Which direction is testing performed (fromjournal/ledger to the source document or vice versa)?



tracing

selecting a source document and then following it into the journal or ledger




- source documents -> journal ( completeness)

vouching

selecting an item for testing from the accounting journals or levers and then examine the underlying sources documents ( occurrence)




-journal-> source documents

How do audit procedures relate to risk assessment (ARM)? Inother words, how does the auditor’s risk assessment affect auditing procedures?

-used to assist the auditor to better understand the business and to plan the nature, timing, and extent of audit procedures (REQUIRED)




- if a control risk goes up, what happens to audit procedures?? -- more tests

Substantive analyticalprocedures – know the steps. What do we mean by expectation precision? Be ableto perform mathematically simple analytical procedures given appropriate informationand evaluate your results (remember the example problem in class).



steps

-develop an expectation


-define a tolerable difference


-compare the expectation to the recorded amount


-------investigate difference greater than the tolerable difference


-------conduct other audit procedures


-accept amount


-document results




will you support or reject?

expectation precision

how closely the expectation approximates the 'correct' but unknown amount

Assessing control risk – what does this mean? When is itrequired? How does it affect our audit strategy (i.e., substantive versusreliance strategy)?



what does this mean?

risk that material misstatements that could occur will not be prevented, or detected and corrected by internal controls

when is it required?

when applying the audit risk model

substantive vs reliance strategy




substantive

set control risk at the maximum for some or all assertions because of one of the following factors




1. controls do not pertain to an assertion


2. controls are assessed as ineffective


3. testing the effectiveness of the controls is inefficient

reliance

plan to rely on internal control and assess control risk below maximum




- only when control risk is low or moderate can you use reliance

Specificsituations that should be regarded as strong indicators that a materialweakness exists.

-identification of fraud, whether nor not material, by senior management




- restatement of previously issued financial statements to reflect the correction of a material misstatement




- ineffective oversight of the company's external financial reporting and ICFR by the company's audit committee




-misstatement in current statements ( usually means inthrall control is correcting misstatement from previous statements)



Types of internal controlopinions and the situations in which each should be issued.



unqualified

opinion signifies that the client's internal control is designed and operating effectively ( no material weakness)

a serious scope limitation

requires the auditor to disclaim an opinion

adverse opinion

an adverse opinion is required if a material weakness is identified ( material weakness must be described)

Requirements for the communication of different types ofinternal control deficiencies.



materail weakness

material weakness- report externally to audit committee and to management

significant deficiency

significant deficiency- report to audit committee and to management

control deficiency

report to management

Be able to perform a sampling procedure similarto the in-class example or the Quiz 4/Exam III examples

attached quiz but look up

Attribute sampling – what is the objective of attributesampling, what factors affect sample size and how do these factors affectsample size?



attribute sampling- the item being sampled either will or won't possess certain qualities or attributes




- use in the study and evaluation of internal control


-determine whether important control policies and procedures are functioning as intended to prevent and detect material misstatements

factors that affect sample size


1. the desired confidence level

the desired confidence level; the desired level of assurance that the sample results will support a conclusion that the control is functioning effectively. Affected by:



-significance of account/assertion


-degree of reliance on the control





2. tolerable deviation rate

tolerable deviation rate; the maximum deviation rate that the auditor is willing to accept and still consider the control effective

the expected deviation rate

the deviation rate the auditor expects to exist in the population

Once control testing has been completed, auditors must makea decision. What is that decision, howis the decision made, and how does the decision affect the rest of the audit?

compare the tolerable deviation rate(TDR) to the computed upper deviation rate(UDR)

if UDR>TDR

conclude that internal control is not functioning effectively.




options


- increase sample size in hopes of supporting planned level of control risk - generally a bad idea


-increase level of control risk, leading to large sample for substantive tests or more effective substantive procedures ( in order to lower detection risk)

if UDR < or equal to TDR

conclude that the internal control is functioning effectively




options


-maintain planned level of control risk, leading to planned level of substantive procedures

Risk of Assessing Control Risk Too High (RACTH)(or risk ofincorrect rejection)/ Risk of Assessing Control Risk Too Low (RACTL)(or risk ofincorrect acceptance) – what they mean in terms of the sample results and thetrue population deviation rate and the implications of RACTL/RACTH on auditeffectiveness/efficiency.

*know graph on PP*


-sample deviation rate = number of deviations / sample size




-UDR = SDR + ASR




-(1-RACTL) that the actual (true) population deviation is less than or equal to % (UDR)

risk are type I error and type II error



type I error- incorrect rejection- test efficiency RACTH




type II error- incorrect acceptance- test effectiveness RACTL

Know the important dates in the audit completion process andhow they relate to contingencies, subsequent events, and subsequent discoveryof facts.



audit completion date

audit completion date: date when auditors have gathered sufficient appropriate evidence on which to base their opinion; this includes the review of audit documentation, preparation of the F/S and related disclosures, and obtaining management representations




* this is also the opinion date ( date on the auditors report)

audit report release date

audit report release date: date on which auditors allow the client to use the auditors report. F/S due dates


-large accelerated filers ( $700 million market cap)- due within 60 days of fiscal year end


-accelerated filers ( $75 milllion) - due within 75 days of fiscal year end


-non accelerated filers- due within 90 days of fiscal year end

Management Representation Letters – primary purpose, date ofthe letter, and what auditors should do if the client does not sign the letter



purposes

-impress upon management its primary responsibility for the financial statements


-corroborate significant oral representations made to the auditor and document the continued appropriateness of those representations


-may establish auditors defense if a question related to these inquires subsequently arises

date of letter

the representation letter ( rep letter) is dated on the same date as the auditors report: the audit completion date

contents of the letter

-management responsibility for the fairness of the financial statements




-availability( to the auditor) of all financial records and data




- management responsibility for the design and implementation of programs and controls related to fraud




-disclosure of significant deficiencies in internal control




-information concerning fraud involving the client

if client does not sign the letter

-scope limitation that is sufficient to preclude an unqualified opinion and is ordinarily sufficient to cause an auditor to disclaim an opinion, or withdraw from the engagement.

who signs the letter

CEO and CFO sign the letter

if letter is not received form the client

auditors should qualify or disclaim an opinion if not received from the client

Subsequent events– what are subsequent events and when do they occur, typical audit proceduresused to identify subsequent events, types of subsequent events (Type I and II), how auditorsshould respond to a subsequent event depending on the circumstances (e.g., whenthe event was discovered, whether the event affects audited balances, etc.), andwhen auditors would consider dual-dating the audit report.



subsequent events

an event or transaction that occurs after that balance sheet date but prior to the issuance of the financial statements and the auditors reports that my materially affect the financial statements

procedures to identify

-review latest interim financial statements


- inquire of officers and other executives


--contingent liabilities or commitments


--significant changes in capital stock, long term debt, or working capital


-read minutes of meeting of shareholders, directors, and committees


-obtain responses to legal letters


-obtain management representations

type I subsequent event

events that provide additional evidence about conditions that existed at the balance sheet date and affect the estimates that are part of the finical statement preparation process.




- adjust financial statements and disclosures to reflect new information ( if material)




-ex


-uncollectable account receivables existing at year end resulting from continued deterioration of a customers financial condition leading to bankruptcy after the balance sheet date




-settlement of litigation after the balance sheet date for an amount different from that previously recorded ( the litigation was pending at balance sheet date)

type II subsequent events

events that provide evidence about conditions that did not exist at the balance sheet date but that arose subsequent to that date




- disclose in financial statements (if material) we do not adjust F/S


-prepare pro forma financial statements ( if very material)- presentation of financial information 'as if' the event had occurred as of the beginning of the period




ex


-purchase or disposal of a business segment


-bond or capital stock issuance


-loss of the entity's manufacturing facility or assets resulting from a casualty loss such as fire or flood


-losses on receivables caused by conditions such a business failure arising subsequent to the balance sheet date

procedures


prior to audit completion date

perform audit procedures and ensure accounting treatment and disclosure

following audit completion date but prior to audit report release date (dual dating issue)

-dual date audit report or extend audit report date


-dual dating is used to limit audits legal liability ( original date of audit report plus date of subsequent event)

following audit report release date

subsequent discovery of facts

Subsequent discovery offacts – what are they and how should auditors respond?

-subsequent to the audit report release date, the auditor may become aware of facts that existed at the audit report date which might have affected the report had the auditor known about them if


1. the facts are reliable and existed at the audit report date, and


2. the financial statements require revision ( so the audit report is affected)




- the auditor should request the client to issue an immediate revision to the financial statements. the reason for the revision should be described in the footnotes of the revised financial statements

Audit reports: know thegeneral purpose of the audit report, the types of audit reports for thefinancial statement audit (i.e., unqualified, qualified, adverse, etc.), thesituations in which each type is issued, and the required changes to thestandard audit report when each opinion type is issued (including the additionand location of an explanatory paragraph, if needed).



purpose

enable shareholders, bondholders, bankers, and other third parties who rely on the financial statements to understand the degree of responsibility taken by the auditor




- are F/S in conformity with GAAP?


- any unusual aspects of the audit examination?


-any unusual matters related to the entity?

types of audit reports


unqualified

expressed an unqualified (clean) opinion



unqualified with explanatory language ( still considered a clean opinion)

-F/S are in conformity with GAAP


-difference between this and standard report is that additional matters are disclosed in report

qualified opinion

-'except for' some matter, F/S are in conformity with GAAP


- material but non-pervasive GAAP violation or scope limitation




modifications


-introductory and scope paragraph remain the same


-add explanatory paragraph preceding the opinion paragraph explaining departure and detailing the amounts involved


-modify the opinion paragraph ( 'in our opinion, except for the matter discussed in the preceding paragraph "



adverse opinon

-F/S are not in conformity with GAAP- pervasive GAAP violation




modifications


-introductory and scope paragraph remain the same


-add explanatory paragraph preceding the opinion paragraph explaining darter and dealing amounts involved


-change opinion paragraph ( financial statements do not present fairly)





disclaimed of opinion

-no opinion issued by auditors- pervasive scope limitation


-independence is violated

Specifically, what do youdo when you face scope limitations, GAAP departures, and GAAP not consistentlyapplied from year to year?





scope limitation

a restriction on an audit thats caused by the client, issues beyond the control of the client, or other events that do not allow the auditor to complete all aspects of his or her audit procedures




- issue scope paragraph

GAAP departures

-adverse opinion if pervasive


-'except for' if not pervasive

lack of consistency

explanatory paragraph

Know the language that’sincluded or changed in the opinion paragraph when different types of financialstatement audit reports are issued (i.e., unqualified, qualified, adverse,etc.).



unqualified

materially reflect

adverse

F/S do not materially reflect GAAP

qualified

except for

disclaimer

we do not express an opinion

location of opinion paragraph


unqualified

after

adverse

before

qualified

before



disclaimer

before

Rule 101: Independence–Know who is a covered member and what independence rules have to say about coveredmembers (e.g., prohibition of certain types of financial and employmentrelationships); Know the independence rules relating to immediate familymembers (spouse, dependent children) and close family members (parents,siblings, non-dependent children); know other types of situations which couldimpair independence for the audit of a public company.

see attached document

Audits, Reviews, and Compilations: Know the differences inthe level of assurance provided by each.



compilation

a compilation is defined as presenting, in the form of financial statements, information that is the representation of management or owners without expressing any assurance on the statements




compilation- no assurance

reviews

-limited assurance


-a review is defined as the performance of inquires and analytical procedures to provide the accountant with a reasonable basis for expressing limited assurance that no material modification should be made to the statements in order for them to conform to GAAP (or another comprehensive basis of accounting)

audits

reasonable assurance

Internal Audit – Understand the key characteristics ofinternal audit, describe the primary mechanism that helps internal auditors beindependent.

-reporting directly to audit committee helps make sure independent



independence and objectivity- how is it achieved?

-organization independence is achieved through reporting structures. typically, internal audit departments should report directly to the audit committee.


-the internal audit charter


-defines authority/ repsonsibilities, scope of engagements, and defines reporting guidelines.


-personal independence is achieved through individual attitudes


-adding value


-----recognizing and analyzing industry, business, and operational risks


-----improving economy and efficiency of operations


-----ensuring compliance with management directives